The ECB and the slump in oil prices

Europe's economic recovery is still on track although uncertainty in the global environment has led Mario Draghi to consider revising the ECB's monetary policy at its March meeting. The movement in the price of oil is one of the main sources of uncertainty because, falling by 72% in the last year and a half, it has kept inflation far from the central bank's target. Below we analyse how far monetary policy should react to these fluctuations in oil.

If the low price of crude oil were temporary, there would be no doubt as to the ECB's capacity to guarantee price stability so it seems evident there should be no active response via monetary policy. However, the bulk of the evidence available suggests that a significant proportion of the correction in the price of crude oil will be permanent. For example, the International Energy Agency, one of the most authoritative voices in this field, predicts a price of 79 dollars per Brent barrel in 2020, a considerably different figure to the 113 dollars per barrel reached in 2012.

The clearest consequence of a permanently lower price for crude oil is the greater production capacity of the European economy, a large importer of the hydrocarbon, as the price of energy is one of the most important costs for many companies. If the economy quickly achieves its new potential, no intervention by economic policy will be necessary. However, if demand does not keep up with the growth in production capacity, the downward pressure on prices would increase, compromising the ECB's mandate which aims to keep inflation below but close to 2%. To date, there has been a steady advance in activity in the euro area, gradually approaching its new potential. However, as suggested by the ECB, the recent intensification of risks regarding the future course of the global economy could slow down this recovery. For example, households and companies might postpone decisions to consume and invest given the greater uncertainty. Deceleration in the emerging economies could also damage exports from the euro area and slow down the economy's growth. Because of this, given the increase in such risks, monetary policy could respond with expansionary measures that would boost the economy if it showed any clear signs of a slowdown.

The second factor that might cause the ECB to act is if the fall in oil prices pushed down inflation expectations, which are fundamental for the implementation of the ECB's policy.1 If workers and consumers had significantly reduced their inflation expectations we would have seen the fall in oil prices passed on to prices in the rest of goods and services as well as wages. Our analysis, presented in the Focus «Low inflation: oil and nothing else?» in this Monthly Report, indicates that lower oil prices have temporarily reduced inflation for other goods and services but it also points out that this does not seem to have affected the recovery in core inflation during 2015. According to our analysis, the lower price of crude oil does not seem to have led to any permanent reduction in the inflation expectations of consumers or workers. In any case, as can be seen in the graph, in the last few years the market's inflation expectations2 have decreased and are now below the ECB's target. What is more, there is now a stronger correlation between the price of oil and expectations. On the other hand, expectations based on economist surveys, which are less volatile than market expectations, point to a much more moderate reduction. Consequently, on the whole the evidence points to the ECB continuing to keep the situation under control although it might be compromised should the price of oil fall much further.

In summary, to date the economic recovery has followed a solid path and the slump in oil prices has not led to indirect effects that compromise long-term inflation expectations. If this scenario continues, the ECB should not respond to the fall in oil prices. However, the central bank must remain alert as an increase in uncertainty or further drops in the oil price could warrant its intervention.

1. The central bank establishes a nominal interest rate but agents base their decisions on the real rate: the spread is determined by inflation expectations.

2. For more details on how market expectations are constructed, see the article «Measuring inflation expectations: the devil is in the detail», in MR02/2015.