Wednesday, July 30, 2008

Oil, The Dollar & ECB Monetary Policy

A fallacy regarding monetary policy and oil have been spread among surprisingly many economics bloggers-including even some whose writings are normally good (meaning Barry Ritholtz and Claus Vistesen).

The idea is that the ECB by raising interest rates will in fact increase price inflation by raising the oil price (This idea, had it been true would by the way have been applicable on all other central banks except the Fed). The chain of reasoning behind this surprising conclusion goes something like this:

- Higher ECB interest rates will make the euro stronger, all other things being equal.
- A stronger euro will raise the oil price, all other things being equal.
- Therefore, it follows that higher ECB interest rates will raise oil prices.

A pretty straightforward syllogism: A (higher interest rates) causes B (stronger euro), B causes C (higher oil price), and therefore A causes C. But the problem is that if one of the premises in a syllogism is false, then the conclusion does not follow. And the second premise contains no less than two errors.

First of all, it is only partially true that a stronger euro will raise the oil price all other things being equal. It will raise the oil price in terms of U.S. dollars and other currencies that the euro rises against. But it will not raise the oil price in terms of euros. To the contrary, it will lower the oil price in euro terms. In fact, the reason why the U.S. dollar price of oil rises because of a stronger euro is because the euro price of oil is lowered.

The reason for this is that as the euro rise against the dollar, this will automatically (by definition) lower the euro price of oil if the dollar price is unchanged. That would mean that the average global price would fall as the Europeans get cheaper oil, while the cost of oil for Americans is unchanged. But that would create a disequilibrium as it would increase the demand for oil in Europe while not reducing American demand (an effect which would be even greater if you also consider the effect on supply). And so, in order to get back to the old equilibrium global average price, the dollar price of oil must rise, both to make oil more expensive for Americans and to limit the price reduction. The end result of a stronger euro will thus be to raise the dollar price of oil, but by a smaller amount than the increase in the euro's exchange rate versus the dollar so as to make oil cheaper for Europeans. What this means is that the increase in the dollar price of oil presuppose (is dependent upon) that the euro price of oil falls, and that thus in euro terms, the second premise is completely false.

Moreover, it is not the case that "all other things are equal" if the stronger euro is caused by higher interest rates. The "all other things being equal" condition only holds for "autonomous" exchange rate movements. If interest rates are increased, then this will decrease European demand for oil and thus lower the global average price, and therefore also the price in both euro and dollar terms.

From all of this it follows that the effect of ECB interest rate increases is ambiguous for the dollar price of oil (as the total demand effect counteract the exchange rate effect) while the effect on the euro price of oil is unambiguously to lower the price (as the two effects reinforce each other).


Anonymous Gum said...

Thanks for this blog!
Really is an eye opener to the universe of contemporary economics and clears up the smoke screens that FED is putting out.

1:17 PM  

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