Oil price drop and the central bankers’ dilemma

The recent drastic drop in the oil price started from the last year has huge impact on various economic agents around the globe. Among them, central bankers have to deal with difficult problem about how they incorporate oil price factor into their policy decisions, particularly in country with low inflation environment like the US. To understand their dilemma, we have to know two major lines of argument how lower oil price affects economy and price.

First argument is that lower oil price should be boon to the economy, since oil consumers can benefit from it. This is particularly true for the country like the US, since relatively large fraction of aggregate demand comes from household consumption compared to other countries, and households would greatly benefit from lower oil price because many Americans drive cars as their main way of transportation. Then, higher disposable income created by this would be expected to be spent on other goods, which will drive whole economy.

Another argument is that lower oil price could lead lower price level in general, which increases the risk of deflation. This argument sounds too obvious since general price level must be lower if oil price is included in the definition of “general price level (e.g. Consumer Price Index)”, but from the monetary policy perspective, central bankers usually focus more on inflation expectations rather than current price movement. This is because while lower inflation rate due to lower oil price will be tapered off unless oil price keep decreasing (remember price level matters for calculating inflation rate), lower inflation expectations (e.g. 3 percent to 1 percent) can have permanent effect on inflation rate. But in either case, it is clear that lower oil price creates deflationary pressure on economy.

A careful reader might see my point on how lower oil price puzzles central bankers. If central bankers believe that the impact based on the first argument is stronger, then they should not keep accommodative monetary policy anymore since inflation is expected to be higher than they desire in this case. On the other hand, if they think second argument is stronger, tightening monetary policy too soon would result in deflation. The recent survey of economic forecasters held by the WSJ reflects that there are indeed two camps of opinions on lower oil price introduced here.

One clue to see which position the Fed will take might be how they assess the risk of deflation in the US economy. For example, Paul Krugman strongly believes that the Fed should not tighten monetary policy because cost of deflation is too high to bear. We should watch the next couple of FOMC meetings carefully to see how the Fed reacts to the lower oil price, since it can be a game changer for the US economy as well as global financial markets.

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