The oil price and monetary policy – a new paradigm

The oil price hit a low of around USD 10 at the end of 1999. Since then it has moved upwards in a series of steps. In recent years it has been one of the most closely monitored components of the Consumer Price Index (CPI), which is a leading inflation indicator. When it topped the USD 50 mark in October 2004 and in March 2005 and, even more clearly, when it passed USD 60 in mid-2005, it brought back painful memories of the severe economic consequences of the 1970s oil crisis. However, in real terms – after adjusting for inflation – the oil price is still lower now than it was then. Another striking factor is that between the mid 1980s and the turn of the millennium the oil price fluctuated around an average of about USD 20. Since then, the average price level and volatility have greatly increased. Although a few years do not provide sufficient evidence to validate a trend, they do raise questions about the background to the oil price hike and its implications for monetary policy. This paper looks at the fundamental factors which suggest that oil prices are likely to remain both high and volatile. It also discusses the implications for monetary policy. Since maintaining price stability is the principal objective of monetary policy, this paper focuses primarily on the impact of oil prices on inflation; the effects on growth are considered insofar as they affect inflation. Section 2 outlines some of the reasons why oil prices are expected to remain high and volatile. Section 3 looks at forecasting oil prices while Section 4 outlines the possible implications of higher oil prices for economic growth and inflation. Finally, Section 5 examines the monetary policy implications of sustained high oil prices. The final section presents our conclusions.