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Bloomberg: Bernanke, Trichet May Find Cheaper Oil Raises Inflation Risks

January 29, 2007 | Bloomberg

Plunging oil prices are relieving one inflation headache for central bankers Ben S. Bernanke and Jean- Claude Trichet, only to give them another.

The same lower energy bills that are removing a source of inflation are also stoking the world economy at a time when it is already growing briskly. That may be enough to force interest rates higher in Europe, and keep them from coming down in the U.S.

``It's a special challenge,'' says Laurence Meyer, a former Federal Reserve governor who is now the Washington-based vice chairman of Macroeconomic Advisers LLC. ``Lower inflation might tell you to ease, higher growth might tell you to tighten. What do you do?''

For Federal Reserve Chairman Bernanke and his fellow policy makers in Washington, the answer for now is ``nothing at all.'' The Federal Open Market Committee, meeting Jan. 30 and 31, is expected to leave its overnight interest-rate target at 5.25 percent, where it has stood since June.

Lower oil prices are ``worth three interest-rate cuts,'' says David A. Rosenberg, chief North American economist with Merrill Lynch & Co. in New York. ``Who needs the Fed, really, in this environment?''

Futures trading shows investors see only a 4 percent chance of a rate cut in the first half of this year, down from 72 percent a month ago. Investors have been reducing their bets as evidence accumulates that the U.S. economy is rebounding on the strength of an improving housing market, higher wages and less expensive gasoline. Consumer confidence reached a three-year high in January, according to the Reuters/University of Michigan's monthly index.


Rosenberg says Americans are enjoying ``the lowest heating bills in two years,'' a windfall that could add 0.4 percent to consumer spending growth this quarter.

The Jan. 26 price of heating oil was $1.59 a gallon, down from $2.14 in August. Crude oil for February delivery sank as low as $49.90 a barrel on Jan. 18, the lowest since May 2005, and down 36 percent from its peak last July. The average price of a gallon of gasoline in the U.S. was about $2.15 last week, down from $2.32 at the beginning of the year and more than $3 in early August.

``Energy prices themselves could be a source of support for growth this year,'' Fed Governor Janet Yellen said in a speech in Reno, Nevada, on Jan. 22.

Trichet's Path

Officials at Trichet's European Central Bank have a similar outlook and are indicating they will continue raising their key rate, now at 3.5 percent after six increases since late 2005.

``We are observing a more buoyant economy in the euro area as a result of lower oil prices, and when the economy is stronger than expected, we have to take this into account,'' ECB council member Lorenzo Bini Smaghi told reporters in London on Jan. 18.

ECB policy makers also say last year's higher energy costs are still filtering through into the prices of goods and services and adding to pressure for higher wages.

``There is a risk that past oil-price increases will have a stronger pass-through than we previously anticipated,'' Axel Weber, president of Germany's Bundesbank and a member of the ECB governing council, said in a Jan. 22 interview.

Germany's biggest labor union, IG Metall, may demand pay increases of more than 7 percent in wage talks that begin next month, union head Juergen Peters said in a Jan. 24 interview. IG Metall is seeking higher pay to give workers a greater share of corporate profits and compensate them for past increases in energy costs.

The ECB's Benchmark

The ECB will raise its benchmark rate three more times this year to 4.25 percent, in part because ``a decline in oil prices will lift European consumption,'' predicts Stephane Deo, chief European economist at UBS AG in London.

The lower prices pose a different problem for the Bank of Japan and Governor Toshihiko Fukui's plan to gradually increase rates to keep from pumping up asset bubbles. The Japanese central bank on Jan. 18 held its overnight rate at 0.25 percent amid concerns energy prices might cause the world's second-largest economy to slip back into deflation.

``Given a decline in crude-oil prices, we can't rule out the possibility core prices will slow to near zero in mid-2007 or even become negative,'' says Ryutaro Kono, chief economist at BNP Paribas Securities Japan in Tokyo. Japan's inflation rate unexpectedly slowed in December as oil prices declined, further reducing prospects for an interest-rate increase.

A `Thrilled' Fed

Some economists say cheaper energy has no disadvantages from the viewpoint of central bankers. ``The Fed's thrilled about falling oil prices,'' says Mickey Levy, chief economist at Bank of America Corp. in New York. Lower energy costs, while giving consumers more spending power, also reduce operating costs for businesses, he says. ``The decline in oil prices, a positive supply shock, raises productive capacity as well as aggregate demand.''

The shock, though, may be more than the U.S. and European economies need, says Simon Hayley, a global economist at Capital Economics Ltd. in London. Last year's record oil prices had a ``visibly smaller'' effect on the world economy than previous price surges, he says. Consequently, falling prices are adding a stimulus at a time when global growth is already strong.

The damage from the recent surge in prices was limited because of ``the slow speed of the rise in the oil price over recent years,'' in contrast to sudden jumps in 1973, 1981 and 1990, according to research by Royal Bank of Scotland Plc. Companies had time to adjust to higher prices and become more energy efficient, says Jacques Cailloux, chief European economist for RBS in London.

Sudden Drop

That means the sudden drop in prices now does more to stimulate faster growth than to damp inflation, he says.

``The oil price decline should produce further upward pressure rather than downward pressure on policy rates as it would be seen as boosting domestic demand,'' says Cailloux. ``It's a pro-growth shock.''

Former Fed governor Meyer says that might have been a more welcome development when the U.S. economy was slowing in mid- 2006. Now, he says, ``we're facing a situation where growth looks more resilient, the unemployment rate is lower, the labor markets are more robust. And now you tell me we've got another $10 decline in energy prices? So there is an upside risk to inflation.''


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