Surging Oil Prices: Central Banks' New Challenge Amid Trilemma

Surging oil prices: a new concern for central banks

Life for the European Central Bank has become even more complicated as surging oil prices add to the trilemma of how to balance slowing economies, the delayed impact of the rate hikes so far and still too-high inflation.

 

Surging oil prices have become the new concern for central banks, aggravating the current trilemma: how to balance slowing economies, still too-high inflation and the delayed impact of unprecedented rate hikes. Interestingly, the answer to this conundrum differs between major central banks.

Looking ahead, the recent surge in oil prices will make things even more complicated as it will both worsen the economic slowdown but also push up inflation (or at least reduce the disinflationary trend). Balancing growth and inflation will become even harder and future interest rate decisions will not only be determined by these two variables but also by central banks’ credibility.

In this regard, central banks most concerned about their credibility and the longer-term impact on inflation expectations could end up continuing to hike interest rates. In the following article, we will mainly focus on the eurozone and the EC

 

Oil price rally likely to continue, but it's not sustainable in the longer run

Oil prices are currently up by more than 25% this quarter and briefly reached 95 USD/b last week. Our commodities analyst Warren Patterson expects oil prices to break above 100 USD/b in the near term as supply cuts by OPEC+ countries more than offset weaker demand due to the global economy’s slowdown.

However, he doesn’t see oil prices remaining above 100 USD/b for long as weaker demand and political pressure to increase supply should help to bring oil prices back to levels slightly above 90 USD/b.

 

Is this the second wave of inflation that we thought would never come?

A few weeks ago, we argued that the current inflation situation is not the same as the 1970s and that a second inflation wave looked highly unlikely. However, we also admitted that in the late 1970s, the second energy crisis was a main driver for the second inflation wave in many countries.

In the eurozone, there were three peak periods for inflation in the 1970s. The first was in 1974, when headline inflation was close to 14%; the second in 1977 with headline inflation above 10%, and then again in late 1979 and early 1980 with headline inflation back at double-digit levels.

Back then, real wage growth remained positive even during the spikes of the oil crises, which allowed inflation to remain above 7% for more than a decade (1972-1984). Indeed, the countries that experienced higher real wage growth for the period also experienced the highest inflation over this period (see chart below).

The current surge in inflation is different in that real wage growth turned negative quickly, which has slowed consumer demand drastically. This makes the chances of a prolonged second spike in inflation much smaller. With inflation currently trending down and wage growth stabilising above 4%, real wage growth is set to soon turn positive again, but we wouldn’t expect it to erase the losses from the past two years.

At the same time, it is important to note that government support and employment growth have limited disposable income losses quite substantially.

 

In the 70s, countries with higher real wage growth also experienced higher inflation

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