Oil and the ECB

By Matthew Hougan

Oil going to $200/barrel and the euro going to $2 are not separate phenomena.

There's a fantastic column in Wednesday's Financial Times by Paul Betts about the link between the European Central Bank, the euro and oil prices. Betts' column picks up on a recent research note from Marco Annunziata of UniCredit, which argued that the key to controlling global inflation was the dollar.

Writing at the beginning of last week, Annunziata noted that the dollar was stabilizing. That stabilization was reflected in oil prices, which moderated from a high of $132/barrel down to $122/barrel. The dollar was helped by Fed chief Ben Bernanke's aggressive jawboning about a strong dollar policy.

But just when the air started coming out of the oil bubble, the ECB issued a statement expressing concern about inflation and said that it was considering raising interest rates. The result? The dollar stumbled and all hell broke loose in the energy markets, with oil posting back-to-back record gains and settling near $140/barrel.

You can see the disastrous cycle here. The ECB has a mandate to keep inflation within a certain range. If inflation rises above that range, the ECB responds by raising interest rates. But higher interest rates in Europe pressure the U.S. dollar, which boosts oil prices. Rising oil prices, in turn, contribute to higher inflation, which encourages the ECB to raise rates again...

It reminds me of George Soros' theory of reflexivity, which states that people's misconceptions about the market - and the actions they take based on these misconceptions - have important impacts on the market itself. In this case, the ECB may be viewing inflation through the wrong lens, setting up this self-reinforcing spiral.

Comments

[Shaggieman:]

Will someone please show Paulson this article. Paulson claims oil and the dollar have no connection which I find very hard to believe.

2008 Jun 12 11:03 AM