ECB may have got it right on oil price effect

Economics/Dan McLaughlin: The price of crude oil has drifted lower in recent weeks, following a sharp increase through April and May. The impact of that rise on consumer prices is evident in the May inflation numbers in Europe and the US, with the June data also likely to show a further negative energy effect.

On the face of it then, rising oil prices are inflationary and as such can be seen as an argument for higher interest rates.

Yet others argue that higher oil prices are ultimately negative for economic growth, having been the proximate cause for a number of past global recessions.

If so, the appropriate policy response for central banks may be to cut interest rates in order to offset the negative impact of higher oil prices.

The latter view tends to dominate US markets and, to a high degree, influences the Fed's thinking on inflation and growth. In contrast, the ECB tends to view higher oil prices as inflationary on balance, so the recent surge in crude prices is taken as negative for the euro area interest rate outlook.

This difference in thinking was clearly demonstrated earlier in the week with the release of the US consumer price index (CPI). Prices rose by 0.6 per cent in the month of May, which was above expectations and took the annual inflation rate to 3.1 per cent from 2.3 per cent in April.

Clear evidence of an upward trend in inflation, one might think, and therefore likely to persuade the Fed to raise interest rates at an aggressive pace, particularly as the starting point is only 1 per cent, a 40-year low.

Yet the financial markets rallied strongly on the data, on the basis that rates may indeed rise on June 30th, the next scheduled Fed meeting, but that the move would be only a quarter-point, rather than the half-point some had feared.

The explanation for this reaction lies in the behaviour of the underlying or core inflation rate, which in the US is defined as the CPI excluding food and energy.

To consumers this distinction is meaningless, of course, as it is the headline inflation rate that hits their pockets, but the counter argument is that food and energy are volatile components of the CPI, particularly on a monthly basis, and are often driven by supply shocks (for example, unusual weather in the case of seasonal food), so one should ignore them in order to get a better insight into the underlying inflation picture.

The core CPI did actually rise on the month, by 0.2 per cent, but this was in line with expectations, and a relief to a market that had seen three consecutive surprises to the upside.

Moreover, the annual rate of inflation on this measure actually declined, albeit marginally, to 1.7 per cent, giving further comfort as to the inflationary pressures building in the economy.

The notion of a core or underlying inflation rate is also utilised in the euro area, although it is not given as much prominence. For example, consumer prices in the euro zone rose by 0.3 per cent in May, taking the annual inflation rate to 2.5 per cent, from 2.0 per cent in March, which was generally seen as negative for the interest rate outlook.

The core inflation rate (here defined to exclude food, energy, alcohol and tobacco) was unchanged at 1.8 per cent, which is a more reassuring picture, but this did not impinge on the market reaction, or indeed, media comment.

One simple explanation for this difference in the US and European approaches to oil -induced rises in inflation lies in the remit of the ECB relative to the Fed.

The latter is charged with the maintenance of stable prices (and full employment) but this has never been precisely defined in terms of an inflation target.

The ECB's mandate also includes price stability - which the Bank itself chose to define, possibly to its regret, as an inflation rate close to and below 2 per cent - that is, it is a specific target relating to the headline inflation rate and not to a core measure. On that basis, an inflation rate of 2.5 per cent breaches the target, regardless of the source of the overshoot.

Is the Fed right and the ECB wrong? In the current situation the main driver of the increase in oil prices is global demand (although there is a speculative element in there as well), which does colour the answer; previous oil price surges have generally been the result of supply shocks, rather than as a result of excess demand.

Consequently the recent acceleration in inflation, although primarily caused by oil prices, may well generate second-round effects in terms of higher wages and other costs because the global economy is booming.

The current oil price may well dampen international growth in 2005, but economic activity is now rising at a pace not seen for 20 years so the impact may be mild.

On this occasion the ECB may well be right to take a more hawkish view and the Fed might have to shift gear to a more aggressive monetary stance in the coming months.

Dan McLaughlin is chief economist with Bank of Ireland