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Last Updated : Feb 28, 2011 08:04 AM IST | Source: Reuters

Oil spike may drive Fed, ECB split

The US Federal Reserve and European Central Bank may go their separate ways if Middle East unrest provokes a sustained, inflationary oil price spike.

The US Federal Reserve and European Central Bank may go their separate ways if Middle East unrest provokes a sustained, inflationary oil price spike.

Crude prices creeping back into the triple digits have sparked concern about slower economic growth and will no doubt reignite two long-running monetary policy debates:

Should central banks have a single inflation-fighting mandate, as the ECB does, or dual goals of price stability and full employment, like the Fed?

Should policymakers focus on headline inflation rates or strip out volatile food and energy prices?

Fed Chairman Ben Bernanke can expect questions on both topics when he delivers his twice-yearly testimony to Congress on Tuesday and Wednesday.

A day later, the ECB holds its policy-setting meeting and will have to judge whether oil prices pose an immediate threat when year-over-year inflation is already above its target. Economists widely expect the ECB to hold rates steady, but they will be hanging on President Jean-Claude Trichet's every word for clues on whether he is leaning toward a hike soon.

Nigel Gault, chief US economist with IHS Global Insight in Lexington, Massachusetts, said persistently high oil prices would curb consumer spending and drive up the still-lofty jobless rate - which would make the Fed less inclined to raise interest rates.

"The inflation-phobic European Central Bank might react differently, which may explain why the euro has been rising in recent days," Gault said.

Indeed, back in mid-2008, when oil prices briefly approached USD 150 a barrel, the ECB raised rates while the Fed held steady.

Dual mandate

In his testimony, Bernanke will probably give Congress an economic assessment that sticks closely to his recent comments that the recovery is strengthening but still not enough to bring about a significant improvement in the job market.

He may also repeat a warning he gave earlier in February that sharp cuts in government spending now could harm the recovery. Republicans in Congress have pressed for deep cuts while Democrats want to keep spending at current levels.

If the parties cannot agree on a spending bill by Friday, the federal government will run out of money for nonessential operations and be forced to close.

Between the spending debate and oil prices, lawmakers will have no shortage of controversial topics for Bernanke. Pricey oil will draw questions on whether the Fed has overstimulated the economy and planted the seeds of runaway inflation.

Bernanke was already under pressure from some in Congress who want to restrict the Fed to a single mandate of price stability. Bernanke has said in the past that the Fed was not seeking any change in its mandate but would "honor" any decision Congress made.

He will be able to point to recent data showing inflation remains unusually low, even with volatile food and oil prices included. Figures on Monday are expected to show tame inflation for January, as measured by the PCE Price Index, a gauge the Fed watches closely.

Eurozone inflation data, also due on Monday, may tell a slightly different story. Economists are expecting a headline reading of 2.4% year-on-year, somewhat hotter than ECB officials would like. But "core" inflation, excluding food and energy, is expected to be up a modest 1.2%.

Trichet said in January that core inflation was "not necessarily a good predictor for future headline inflation," a comment that led many investors to think an ECB rate hike might come sooner than anticipated.

Perhaps the most important US data point - employment - is due on Friday, too late to bolster Bernanke's argument that the economy still has significant slack and is no imminent danger of overheating.

Economists polled by Reuters expected Friday's report to show a net 175,000 jobs created in February. But they expect the unemployment rate to inch up to 9.1% as some discouraged workers resume the job search.

"For the Fed to start hiking rates, particularly this year, we would need to see a much more rapid decline in unemployment accompanied by rising core inflation," said Paul Ashworth, chief US economist at Capital Economics in Toronto.

"The bottomline is that we simply don't see that happening."

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First Published on Feb 28, 2011 07:20 am
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