MNI INTERVIEW: Oil Shock Means Europe Needs Higher Rates

Oil price shocks have a more lasting effect on households’ inflation expectations in Europe than in the U.S., and European policymakers should act decisively in response, Chicago Fed advisor and economics professor Christiane Baumeister told MNI.

While the pass-through of energy price increases to core inflation and expectations is much faster in the U.S. than in Europe, the effects linger longer in Europe, justifying policy tightening, said Baumeister, formerly a senior researcher at the Bank of Canada and now a professor at Notre Dame University. (See MNI INTERVIEW: Long Fed Pause Looms On Iran Shock - Sahm)

"It really gets more ingrained in inflation expectations, and the second-round effects are lasting much longer, which, in my view, calls for decisive action," she said. "In my mind, there is no doubt what both the ECB and the Bank of England ought to do right now, especially coming out of the high inflation episode not too long ago.”

PAUCITY OF ANALYSIS

Baumeister's research  suggests that central banks should do more to consider the risks around potential energy shocks, rather than their current practice, which is largely limited to plugging oil or gas futures curves into their economic projections.

"One of the downsides already from relying on the futures curve is that you don't know what determines prices, and you do not have risks directly built in," she said.

Standard central bank practice effectively takes a single future oil price path instead of considering the entire distribution of possible outcomes over the forecast horizon.

"When we think about tail risks, or the danger that low probability but highly damaging events can occur, [policymakers should] take that uncertainty into account,” she said.

While the Bank of England has used fan charts to show the risks around its central economic projections, it could also put probability fans around the energy price assumptions as well as carrying out energy shock scenario analysis, in Baumeister's view.

"I think they could use the models to run these kind of 'what if?' questions, and then also feed that back into the projections for the economic outlook," she said.

SUPPLY DISRUPTIONS

Another shortfall in focusing on price curves is that they do not fully capture supply disruptions, which have their own hefty economic effects.

Following the initial Iran war shock, the European Central Bank "was very fast to put out a scenario"  based on alternative oil price paths with confidence bands, but without spelling out how they were constructed, whereas "it's clear that we need to model the physical shortages of supply, because that's what is driving the price dynamics," Baumeister said. (See MNI SOURCES: ECB's Ukraine Lesson Lowers Oil Shock Tolerance)

"It's not just central banks that do not factor the physical determinants of prices into their assessment, but also traders in futures markets seem oblivious to the actual physical shortage created by current events," she noted. 

"Typically, the price should reflect physical shortages of supply, which first affect refineries and then the downstream sectors, but currently futures prices are lagging behind that physical market reality.”

Central banks should build up and retain energy market expertise as shocks seem to be becoming more frequent, according to Baumeister, who added that the Ukraine crisis has already led to significant changes in how the oil market operates.

"There's a tendency to quickly forget once we're past the crisis, then it's like, okay, we don't really need to do any risk assessments for energy markets," she said.

One exception to this relative paucity of analysis is a recent paper by the Dallas Fed’s Lutz Kilian, with whom Baumeister has previously collaborated, in which he and co-authors set out scenarios for the Iran shock based on oil supply disruptions. But other central banks have work to do, in her view.