Oil prices and monetary policy

In 2002 I was seconded at the ECB, and tasked – with another, from the research department – with writing a note to the Governing Council on oil prices and monetary policy.  If I remember correctly, in the 3 months up to the time we were writing the note, oil prices had risen in euro terms by 1/3.  Consequently, my coworker and I hit on the idea of beginning the note with the phrase ‘In the last 3 months, oil prices have risen by a 1/3 in euro terms’.  This sentence got purged on the grounds that it was ‘too alarming’, and replaced with ‘From time to time the oil price changes’.   I hope that material flowing to the ECB policymakers is written more directly now, or, if not, that the custom widespread at the time – according to my contacts in member state central banks – of disregarding entirely briefing emanating from the centre, is still prevalent.

Right now, arguments could be made for doing nothing, cutting, or even tightening in response to the oil price fall.  But I hope that in so far as this is possible, they loosen, since this would be the policy that minimises the risk of making the worst mistakes.  In the jargon, this would be the robust thing to do.

The argument for doing nothing is that oil-intensive-final good prices like refined petroleum are highly flexible, and can therefore be ignored.  (Modern orthodoxy says just stabilise sticky prices).  Or that the effects on inflation will be so temporary that they will be gone before anything can be done about it.

The argument for loosening is that on account of oil being a major input, it will raise potential output relative to actual output.  Which in models like those central banks uses is deflationary.  Also, if inflation expectations are extrapolative, ie they look at changes in total inflation and project those forwards, a temporary oil price fall would lower inflation expectations, transmitting into core inflation.  (Inflation itself being lower on account of the fall in expected inflation).

It’s conceivable there’s an argument for tightening.  If the demand/confidence effects of the improvement in the terms of trade for a net oil importer come through before the boost to potential output.

By far the largest risk to me is the risk of setting too-tight policy, since there is no proven or politically feasible instrument to use to loosen further in the ECB, and, to a lesser extent, in the US or the UK.    So if possible, better to loosen now rather than face the possibility of needing to, but being unable to loosen by a great deal more later.

Events might prove a loosening wrong, of course.  But in that case the ECB can simply raise rates, or the Germans can gallop to the rescue and tighten fiscal policy.  And anyway, an inflation target overshoot would be welcome for most.

So, ECB policymakers, recall those wise words [inserted by my superior] ‘from time to time the oil price changes.’  Most often, the risks are balanced, and it might be safe to ignore those changes.  But not now!