Central bankers set out to ignore temporary ups and downs in markets and economies, focusing instead on how inflation will behave in the medium term. But sliding oil prices mean they can do so no longer.
European Central Bank Chief Economist Peter Praet wrote in a German newspaper on January 13 that the impact of falling energy costs on inflation is not temporary. As he points out, lower oil prices can drive down prices in sectors such as transportation and can eventually lead to lower wage settlements.
That is even more the case when oil prices have been falling as long and by as much as they have. The price of a barrel of Brent crude nearly halved in 2014, declined 30 per cent in 2015, and has already fallen 16 per cent since the start of this year to its lowest in nearly a dozen years.
Such falls are a nightmare for rate-setters, who don't control energy costs and have deployed all sorts of unusual monetary policies, such as negative policy rates and bond purchases, in a failed bid to revive inflation.
Financial markets got this message some while ago. The clearest sign of this has been increased volatility in even long-term measures of market inflation expectations, such as one which tracks how investors see inflation behaving over a five-year period beginning five years from now. Long-range inflation expectations theoretically should be immune to swings in energy costs which are happening right now. But in fact they have tended to move almost in lockstep with oil prices.
The euro zone version of this so-called five-year/five-year forward rate has fallen to a three-month low of 1.62 percent, while its U.S. counterpart is also at its lowest since October 2015. Praet's admission, that oil and inflation can mix after all, will only confirm investors' scepticism about central bankers' ability to push up consumer prices.
