Friday, August 15, 2008

The Effect Of Recent Market Movements On Monetary Policy

One rarely discussed aspect of recent market movements is how they will affect monetary policy makers. And even when they are discussed, the discussion is usually misleading. This is a real shame, because this aspect is important. Economic events are often connected to each other, and will frequently either be self-reinforcing or self-preventing.

The recent market movements that I am referring to means primarily the drop in the price of oil and other commodities and the dollar rally against the euro in particular. The effects that I will focus on are the effect on real growth and price inflation.

For the U.S., the effect will clearly be to lower inflation. This is primarily the effect of the lower commodity prices, but this effect will be reinforced by the stronger dollar which will also lower other import prices compared to where they would have been without the recent decline. Note however that this will in most cases not mean actual price declines. Instead it will mean that price hikes that otherwise would have been implemented will be cancelled. While non-fuel import prices have risen sharply, they have in fact risen a lot less than you would have expected them to given the magnitude of the previous dollar decline. Despite the fact that domestic inflation has often been quite high, export prices in China and many other countries have in fact fallen in terms of yuans and the respective domestic currency in other countries. So despite facing rising costs of both labor and commodities, exporters have in fact accepted to receive lower prices in terms of their domestic currencies.

The reason why they accepted this massive margin squeeze is likely that they expected the dollar to recover eventually and didn't in the meantime want to lose market share that could be difficult to recover. In the long run these low (in many cases negative) margins would have been unsustainable, and would force them to raise prices eventually, but now that the dollar is recovering they can maintain their current prices. So, while it stops further price increases, it won't mean price cuts in most cases.

Anyway though, the point is that this will clearly lower U.S. inflation compared to how it would have been otherwise. The effect on U.S. growth is more ambiguous. On the one hand, the lower price of imports and particularly oil imports will boost domestic purchasing power and therefore boost growth (at least properly measured growth). But on the other hand, the stronger dollar will likely hurt exports and also increase import competition and so put a stop to the reduction in the non-petroleum trade deficit. As the theoretical net effect is ambiguous, it is unclear whether the actual net effect of these counteracting forces will prove to be positive or negative. But at any rate, whatever net effect arise in either way it is likely to be very small, and can given the uncertainty of the direction be treated as nonexistent.

So for the U.S., the effect will be to lower inflation, while having no effect on growth. It should be clear that as the Fed tries to strike a balance between inflation and growth, the inflation-lowering effect will make the Fed more dovish, i.e. less eager to raise interest rates.

Turning to the euro area, the effects will be somewhat different. On the one hand, the recent market movements have a somewhat ambiguous effect on inflation. On the one hand, the decline in the price of oil and other commodities (which have been less dramatic in euro terms than dollar terms, but nevertheless significant) will lower inflation. On the other hand, the weak euro will lift non-commodity import prices relative to how they otherwise would have been (although for similar, but reversed reasons as the ones related in the American case, that may not mean actual price increases but cancelled price cuts). As the theoretical effect on price inflation is ambiguous, this also means that the actual empirical net effect will likely be little, which means that we can for practical purposes treat it as non-existent.

The effect on growth is however very much unambiguously to raise economic growth. Because the euro area, like the U.S. is a net importer of oil, it will see its purchasing power rise from lower oil prices. Meanwhile, the weaker euro will reinforce this effect by also increasing nonfuel net exports.

With little or no effect on inflation and a clearly positive effect on growth, the recent market movements will clearly make the ECB more hawkish, and so ease the pressure on them to cut interest rates, and perhaps even enable them to raise them further.

With the Fed becoming more dovish and the ECB becoming more hawkish as a result of these market movements, the recent trends will eventually become self-preventing. It will likely take some time before the markets figure this out, so don't expect this fact (or the many other facts that argues against the sustainability of recent trends that I've discussed recently) during the coming days and probably not even the coming weeks. But eventually, markets will be forced to face these facts.


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