Watch out: oil still has the power to shock
Oil, it seems, still has the power to shock. It's impossible to know where the political turmoil in Egypt and the rest of the region might end, but one thing it has already done is further drive up the oil price, threatening to wreak havoc with the still fragile recovery in many advanced economies.
The oil price is high while the advanced economies are weak, the reverse of what's happened in the past. The West is seriously out of sync with the oil price Photo: AP
How serious a problem is this, and how should policy makers react? The first thing to note is that high oil prices nearly always play some sort of role in recessions. In the US, all post-war recessions have been preceded by an oil price spike. The last all-consuming one is widely attributed to the fallout from Lehman Brothers' collapse, but in fact record prices at the pumps had put consumer confidence and spending into a tailspin several months before. Lehman was only the icing on the cake – more of a symptom than a cause. Americans took one look at the price of filling up, and decided to stop spending.
The second point to note is that price shocks of this sort have always been a policy nightmare for central banks. A rising oil price is both inflationary, in that it adds to the cost of living, and deflationary, in that it also acts like a tax by taking money out of people's pockets. The cost to the US economy of last year's rise in the oil price was approximately $120bn (£74bn), or nearly 1pc of GDP. That's a big hit.
Should policy makers therefore react by tightening monetary conditions to choke off any inflationary consequences, or by easing them to counteract the negative consequences for demand?
Both these responses have been tried in the past, with disastrous consequences on each occasion. In the 1970s, the oil price shocks were met by a loosening of policy in the US and Europe, but this only succeeded in further embedding the inflationary problem. Mindful of this, the European Central Bank raised rates in July of 2008 to deal with sky-high oil prices, only to run headlong into the most serious recession since the 1930s.
The ECB Governing Council meets on Thursday to decide on what to do this time. We can but hope that it has learned from past mistakes. Does policy remain in the sway of the Germans, with their strongly growing economy, or will the needs of the deflating periphery continue to dominate?
