Despite growing efforts to increase transparency in developed countries, monetary policy continues to exude an aura of mystery in many ways. Although interest rate movements are made public instantly, the truth is that no one knows with certainty what happens at each meeting (the minutes that are published are usually a summary ad hoc) and much less the real information that central bankers have. One of their jobs to bring inflation to the target is to generate expectations, that is, even if they know that the economy is going to collapse or that inflation is going to skyrocket, part of their mission is to prevent those expectations from being generated. In a somewhat crude and exaggerated way, it can be said that a central banker can lie to you until the lie is no longer tenable, but this is part of his job. As a very clear example of this dynamic, the European Central Bank (ECB) has been ensuring for years that its rate decisions are not related to oil or energy… however, There is a graph that seems to say quite the opposite..
In 2021 and part of 2022, the ECB’s speech was clear: the rise in the price of inflation is caused by the rise in energy prices (especially oil) and It’s a temporary thing.so raising interest rates does not make sense. They also noted verbatim that “higher interest rates would not lower the price of energy.” The different officials of the ECB, like other colleagues from their Western peers – see those of the US Federal Reserve -, claimed in their appearances in the media and forums that it was necessary to focus on underlying inflation, since the volatility that in the last medium century they have experienced energy prices did not allow us to see the forest well.
Some experts such as those from the Oxford Economics analysis house collected this theoretical scheme of thought of central bankers in the following way: “1) The rise in inflation will be temporary and the energy inflation blip will have dissipated before monetary policy has had a significant impact on activity and prices. 2) Rising energy prices usually act as a tax on the economy and reduce economic growth, and therefore underlying inflationary pressures, beyond the short term. And 3) the secondary inflationary effects of higher energy prices tend to be small and limited to a few sectors, such as air transport, where oil prices have a huge impact on costs.” Come on, energy has almost nothing to do with the movements of a central bank.
However, economists at Deutsche Bank believe this is not the case. A few weeks ago, Jim Reid, global head of economics and research theme of the German entity, sent its clients an oil graph on which the most important movements of the ECB since its creation were superimposed. This economist, who is Deutsche Bank’s ‘star’ strategist, assured that “To understand the way forward for the ECB, it is useful to take a look at the chart that Francis Yared (another Bank of Germany economist) has used over the years, and which shows how the year-on-year change in oil prices has generally been a big driving factor in the ECB’s policy changes.”
Reid also mentions an article by his colleagues Peter Sidorov and Mark Wall in which he highlights “how much ECB policy has been linked to oil in recent years“, and given the great uncertainty that exists at the moment about the price outlook, especially given the geopolitical uncertainties, it is not surprising that the ECB wants to keep its options open.”
The ECB publicly assures that energy does not determine its monetary policy, but the facts seem to say the opposite. It is true that an inflationary shock caused by energy should not alter inflation in the medium term, but if this shock lasts longer than expected, experience shows how oil ends up filtering into all layers of inflation until it generates the risk of the appearance of a price-salary spiral, as has been seen this last time.
This is how oil leaks to the rest of the economy
Oil is an essential component in the generation of energy, the transportation of goods and people, and the production of certain derived products, such as plastics and fertilizers. When the price of oil rises, as it did in the 2021-2022 period, energy costs increase immediately, making the transportation of raw materials and finished products more expensive. Up to this point, the ECB would be right and the rise in inflation would remain temporary. However, if crude oil prices do not fall immediately, this ends up raising costs for companies in sectors such as manufacturing, agriculture and commerce. To protect their profit margins, companies pass these higher costs onto the final prices consumers pay, driving initial inflation.
When prices rise steadily due to higher oil prices, workers They usually begin to demand salary increases to protect their purchasing powerespecially in environments like the current one in which labor markets are very tight. If companies agree to these demands, labor costs increase, reinforcing inflationary pressure. This phenomenon, known as the second round effect, can lead to the feared price-wage spiral that consolidates inflation at higher levels. Furthermore, economic agents’ expectations about future price increases can be anchored at high levels, perpetuating the inflationary cycle.
In this way, as oil affects a greater diversity of sectors, inflation ceases to be a specific energy phenomenon and becomes a broader, more structural problem. Widespread price increases mean that traditional containment measures, such as interest rate increases by central banks, may be less effective. This is because inflation no longer responds only to short-term supply and demand imbalances, but to profound changes in the structural costs of the economy.
A review of the oil-ECB idyll
Although the ECB’s history is brief in historical terms, this approximate quarter of a century serves to corroborate the trend. The first episode goes back to 1999 and 2000, with the central bank just getting started. If in the spring of ’99 the deposit rate was 1.5%, then a cycle of increases began that intensified in 2000, taking this rate to a maximum of 3.75% in October of that year. Precisely in this period, a barrel of Brent, the reference crude oil for Europe, had risen from 15 dollars to exceed 35 in August 2000. The other side of the coin was experienced the following year. The barrel fell from that peak to $19 and the ECB cut the depo rate to 2.25% in November 2021.
The phenomenon was seen even more clearly in 2005. That summer, the barrel of Brent jumped from 40 dollars to almost 67. In December of that year, the ECB began a cycle of increases that began with the depo rate at 1.25% and which ended in the summer of 2007 with the rate at 3%. In that same period, oil had already threatened to break the resistance of $90.
More significant and remembered was the case of 2008, dubbed the ‘first Trichet mistake’, in reference to the then president of the ECB, Jean Claude Trichet. At the July meeting of that year, with the great financial crisis in its eleventh month and the economy cracking, as this article from elEconomista.es, The ECB decided to raise the price of money by 25 basis points.
The argument given by Trichet and his people was that inflation stood at 4% year-on-year in mid-2008, double the central bank’s target. Needless to say, in June 2008, oil, spurred on by China that a few years earlier had begun to import it heavily, reached the scandalous level of 138 dollars per barrel. The immediate collapse of crude oil prices to $35, which marked the final implosion of the crisis, was followed by an overwhelming cycle of ECB rate cuts that brought the deposit rate to a meager 0.25% in May 2009. .
Jumping to 2011, comes the perhaps most sadly remembered second ‘Trichet error’. With the eurozone already open due to the debt crisis, the ECB raised rates in two consecutive meetings, in summer and spring. At that time, peripheral bond yields were skyrocketing (Spain, Greece and Portugal were struggling to find demand in the markets), but fear of a resurgence in inflation led Trichet to raise interest rates in July 2011 to try to appease the recent increase in inflation that rebounded in the heat of the rise in oil. As China had not experienced the blow of the great crisis like the West, the Asian giant continued buying oil and Brent had recovered to $126, just before the French banker’s second ‘mistake’.
The resounding change of register that marked the change of baton of the central bank to Mario Draghi also showed measures that followed the score of oil. The arsenal deployed by the Italian in 2015 and 2016, not only rate cuts, but the ambitious quantitative stimulus program (QE, purchases of sovereign bonds), followed two abrupt declines in Brent, to $47 in January 2015 and up to 33 at the beginning of 2016. The great trigger was the takeoff in the US of the technique of frackingwhich potentially increased the supply. The prices of ‘black gold’ were sunk as soon as the prompt and expected reaction of Saudi Arabia, the great ‘producer’, arrived: flooding the market with crude oil to try to overthrow these American companies. At the same time, Draghi’s ECB began reducing stimulus when Brent prices returned to around $80.
Moving forward almost to the present, the collapse of oil due to the initial outbreak of covid in the West in 2020 – even negative prices were recorded in the futures markets – had its response from the ECB in the deployment of the pandemic bond purchase program (PEPP). ) with Christine Lagarde already at the controls: more stimulus – a real bazooka – to some types that were still negative. How, the back of the coin would be seen after two years. The rigors of the Russian invasion of Ukraine – energy uncertainty on a global scale – skyrocketed the price of oil, once again with the barrel piercing upwards of 120 dollars at the gates of summer. A summer in which the ECB began to ride an aggressive path of rate increases and the end of stimuli that only in the last meetings has it begun to be reversed.
The fall in the price of oil, which is currently quotedity at $71, is allowing the ECB to lower interest rates with the certainty that inflation will not revive, at least in the short term. The crude oil market is in a somewhat contradictory moment: while The supply is at maximum levels and showing great solidity (this is a bearish force for crude oil), geopolitical risk is also at historically high levels. For now, the strength of the supply force is what dominates, which has led crude oil to correct intensely since it reached $120. Meanwhile, the ECB will continue to lower interest rates.
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