Oil prices, inflation and the FT’s good advice for central bankers

This is from the Financial Times’ FT View:

Pity the analyst forecasting today’s global economy. For every signal warning of stagnation there is another glowing green for go. But through this blur of clashing indicators it is possible to discern some consistent themes.

The clearest is weak inflation. The main cause is oversupply in the oil market where prices have fallen by one-third since the summer. With other commodities from cotton and hogs to wheat and soybeans similarly cheap, countries that rely on imported food and fuel have had a welcome boost.

American consumers in particular benefit from cheap fuel, which helps to explain growing momentum in the US economy. Strong jobs numbers on Friday confirmed a growing recovery. These bullish spirits are mirrored on Wall Street where the stock market has rebounded by 10 per cent since the turmoil of October.

But any student of the Great Depression would caution against seeing disinflationary forces in a purely positive light. In Japan and Europe, the persistent downwards trend in inflation is also a reflection of weak incomes. If left unchecked, this threatens to entrench a low-spending, deflationary mindset. Outside of a big slowdown, wage growth in much of the developed world has never been weaker. Even the most ambitious monetary policy can be undermined if pay packets are not growing. Instead of being spent, cash accumulates on the balance sheets of businesses unwilling to invest…

…Monetary policy provides the best key to understanding the variegated global picture. The central banks of the US, UK and Japan all adopted easier policies and were rewarded with an upturn. Given weak wage growth and a lack of fiscal support, such stimulus ought to continue.

Europe is an unhappy exception. Despite German misgivings, low interest rates are no evidence that money is too loose: nominal GDP growth stutters along at less than 3 per cent, a clear sign that the stance is much too tight. In recent years the ECB twice made the mistake of raising rates too soon, and thereby punished Europe with a deeper recession and a worse fiscal crisis. If its president Mario Draghi cannot ease policy further, the consequences will be just as serious.

The welcome boost provided by cheaper oil may help the global economy accelerate over the next year. Even Europe could participate, if only its policy makers would stop confusing the brake with the accelerator.

Do I need to say I agree with 99% of this? Yes, lower oil prices is mostly good news to the extent it reflects a positive supply shock in the oil market and yes if that was the only reason we are seeing deflation spreading then we should not worry.

However, take a look at any indicator of monetary condtions in the euro zone – the collapse in the money base since 2012, meager M3 growth, no NGDP growth, higher real interest rates, a stronger euro (since 2012) and sharply lower inflation expectations – and you should soon realise that the real deflation story in the euro zone is excessively tight monetary policy and the ECB need to do something about that whether oil trades at 40 or 140 dollars/barrel.

PS I don’t think the same story goes for the US. The recent drop in US inflation does not on its own warrant monetary easing. The Fed just needs to keep focused on expected NGDP growth and there is no signs of NGDP growth slowing in the US so I don’t think monetary policy is called for in the US.

PPS For some countries – oil-exporters with pegged exchange rates – lower oil prices is in fact monetary tightening – see here.

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2 Comments

  1. Benjamin Cole

     /  December 6, 2014

    PS I don’t think the same story goes for the US. The recent drop in US inflation does not on its own warrant monetary easing. The Fed just needs to keep focused on expected NGDP growth and there is no signs of NGDP growth slowing in the US so I don’t think monetary policy is called for in the US.–Lars-

    Egads Lars, what is wrong with some robust economic growth, some some strong demand for labor? Would some boom times be so bad?

    Is 3% inflation TEOTWAWKI if it brings on 3% real growth and 3% unemployment?

    Reply
  2. Adam

     /  December 11, 2014

    http://www.federalreserve.gov/releases/h6/discm3.htm

    “M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits.” – Nov. 2005

    Interesting that it decided this just a few years before M3 began to decline even as M2 expanded at an increased rate. What specifically did they miss? Also, what is the rational basis for separating large deposits and institutional money market funds from other aspects of the money supply? They seem to be quite similar in their effect. An M3 chart explains the recent recession and slow recovery quite well, while M2 would have you think (as many hawkish monetarists did) that we should have substantial inflation.

    Reply

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