The Fed's Oil Price Challenge

by: Desmond Lachman

Recent geopolitical developments in the Middle East and in Ukraine now threaten to complicate the Federal Reserve's strategy of gradually exiting from quantitative easing. Since those geopolitical developments pose the real risk of a sustained increase in international oil prices, the Fed might be faced with the challenge of lower economic growth and higher inflation than it desired. This would present the Fed with a real dilemma as to what to do with monetary policy.

The very real risk of Iraq lurching to a full scale civil war could have a major impact on international oil prices. After all, with current oil production of around 3 million barrels a day, Iraq is OPEC's second largest oil exporter. Currently it would be difficult to compensate for any major disruption of Iraqi oil supply since such a disruption would be occurring at a time of ongoing supply problems in Libya and Syria. It would also be occurring at a time that Saudi Arabian excess capacity is limited to around 2 million barrels a day.

Russia's apparent effort to destabilize Ukraine through support to the separatists and through restricting natural gas exports could also pose a threat to global energy prices. Since such a restriction in Ukrainian gas supply could stop the supply of Russian gas that flows through Ukraine to Europe, one would think that a 15% drop in Europe's natural gas supply that would result from such a restriction on Russian gas exports would put further upward pressure on global energy prices.

Oil Price Lachman

Research by the OECD and the IMF suggests that a sustained increase in international oil prices could have a meaningful impact on both U.S. and global economic growth and inflation. That research suggests that a sustained $10 a barrel increase in international oil prices could reduce both U.S. and global economic growth by around 0.2% while it could increase inflation by around 0.3% after a year's lag. Applying these estimates to the approximately 15% increase in international oil prices that has occurred over the past year, one would expect that if it were sustained U.S. GDP economic growth could be 0.3% below the level it would otherwise have been while inflation could be 0.45% higher.

If oil price increases associated with rising geopolitical tensions were to be limited to current levels, the Fed could probably continue along its current path of exiting quantitative easing without a real threat to its implicit inflation target. However, a meaningful rise in oil prices from current levels would probably require a faster pace of exit if the Fed were to retain its inflation fighting credibility. It would need to do so even in the context of a very much weaker economy than desired.

With inflation in Europe presently running at 0.7%, or around a third of the ECB's inflation target, the ECB would be under less pressure than the Fed to react to higher international oil prices by any tightening in monetary policy. This might allow for a weakening in the Euro as U.S. and European monetary policy stances further diverged. That in turn could provide some offset to rising oil prices on European economic growth prospects.