CENTRAL BANKS MUST ADDRESS RISING OIL PRICES / THE FINANCIAL TIMES MARKET ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

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Markets Insight

March 19, 2012 11:45 am

Central banks must address rising oil prices

By Andrew Sentance

In 2008-9, chaos in global financial markets led to a large recession across the world economy. The recovery from that recession has been hampered by a different markets problem: rising and volatile energy and commodity prices.



In 2010, the world economy bounced back more strongly from recession than most forecasters were expecting. But, with stronger growth came higher energy and commodity prices. The oil price fell from nearly $150 a barrel in mid-2008 to about $40-45 in early 2009. But it did not stay there for more than a few months. By early 2010, it was back up to $75-80, on the way back to above $100 again.

 

Last year saw a broader-based rise in commodity and energy prices, pushing up inflation rates around the world. The squeeze on consumers generated by this price surge was the main factor responsible for the slowdown in global growth last year. Inflation rates peaked in most countries last autumn. However, as the world economy has started to show more signs of life in the early months of this year, the oil price is picking up again, with Brent Crude back up to around $125.

Looking back over the past decade, an ominous pattern is emerging. The era of relatively stable energy and commodity prices which prevailed from the mid-1980s until the early 2000s has given way to a prolonged period of rising and volatile prices. This reflects the fundamental balance of supply and demand. New sources of energy supply and natural resources are costly and slow to come on stream.


But demand is being driven up by the activities of the 6.8bn people now living on the planet, with the vast majority of them participating in the global economic system and aspiring to a higher standard of living. We have never been in this situation before.


Since the early 2000s, whenever we have seen a combination of strong growth in Asia and emerging markets and reasonably healthy growth in western economies, we have also experienced a burst of energy and commodity price inflation. The first occurred in 2003-5, the second in 2006-8, and the third in 2009-11. If, as many forecasts suggest, the world economy starts to gather momentum again as we move through this year, we are set for another phase of rising energy/commodity prices, carrying through into 2013 and possibly 2014. This is likely to push up inflation worldwide and may eventually be a threat to growth as living standards are squeezed.


We cannot guarantee, either, that the next jump in energy and commodity prices will be the last. The world economy suffered a prolonged period of such price rises and volatility from the late 1960s until the early 1980s. And that was in an environment when the “global economy” was a small club of western economies, accounting for a minority of the world’s population. We now have a truly global economic system, with a world population that has doubled since the mid-1960s. In this environment, it is hard to predict when this phase of global price volatility might end.


A consensus is emerging that countries need to do everything to stabilise oil prices following the market volatility of 2008.


How should policymakers react? Central banks in western economies have generally turned a blind eye to the surges in inflation created by successive waves of energy and commodity price inflation.

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Initially, this was because we started from a disinflationary position in the wake of the late 1990s Asian crisis. Then it was because of the imperative to deal with the global financial crisis. More recently, monetary policymakers have tended to treat bursts of globally driven inflation as temporary and not warranting a policy response.


The key to the ability of central banks to respond in this way is the stability of inflation expectations and underlying confidence in their ability to sustain stable prices in the medium term. But continuing to tolerate phases of relatively high inflation will raise questions about their commitment to price stability. In my view, a policy of “leaning against the wind” of high energy and commodity prices – by seeking to influence the exchange rate and expectations of price increases – is more likely to be successful in anchoring inflation expectations and sustaining central bank credibility.



In the 1970s, the western central bank that took the inflationary threat from energy and commodity prices most seriously – the Bundesbank – emerged from that period of volatility with its reputation greatly enhanced. Others, including the UK, faced a long battle against high inflation and fared less well. Currently, the focus of the western central banks is on combating the aftermath of the financial crisis rather than the threat from energy and commodity prices. That judgment may have been right in 2008-9. But a renewed burst of commodity and energy price inflation could require a different policy approach. 

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Andrew Sentance is senior economic adviser at PwC and a former member of the Bank of England Monetary Policy Committee, from 2006 until 2011

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Copyright The Financial Times Limited 2012.