Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 4 Monetary Policy and Inflation

Impact of Oil Price Shocks

In view of the recent sharp increase in international crude oil prices, this Section undertakes an assessment of their impact on economic activity. Nominal international crude oil prices have increased sharply recording new highs in the second half of 2004. The increase, however, needs to be viewed keeping in mind the sharp decline during the period 1999-2000. Notwithstanding this order of increase, prices in real terms remain less than the levels reached in 1981. An increase in oil prices affects both supply and demand in the economy. A hike in oil prices leads to an increase in the input costs for firms, reduces their profits which induces them to lower their output. As oil dependency has declined in industrialised countries over time, this supply side effect has weakened in these economies. In contrast, this effect remains significant for developing economies, in view of their increased oil dependency. On the demand side, higher oil prices reduce consumption and investment in the economy. Both supply and demand effects reinforce each other leading to a reduction in output. Consequent variations in exchange rate can add to these effects. High inflation might lead to a tightening of monetary policy, the macroeconomic performance of the three key monetary regimes: exchange rate targeting countries, money growth targeting countries and IT countries. They find that what matters most for macroeconomic performance - low and stable inflation and output stability - is clear-cut quantitative goals by the monetary authority. Both having and hitting quantitative targets for monetary policy is found to be systematically and robustly associated with lower inflation. The exact form of the monetary target matters somewhat, but is less important than having some quantitative target. Successfully achieving a quantitative monetary goal is also associated with less volatile output.

In a similar vein, Sterne (2004) makes a distinction between inflation targeting and inflation targets. While only around 20 central banks follow the inflation targeting approach, a large number of central banks - such as, India - make public some sort of loose inflation targets (which could take the form of inflation forecasts/projections rather than targets per se). According to one survey, out of 95 countries, as many as 57 countries had some sort of inflation target/ projection/forecast. Such inflation targets/ forecasts increase transparency and help to reinforce societies support for low inflation policies. They also provide a platform to the central bank to voice its independent opinion. In cases where inflation targets/ forecasts are missed, a central bank can provide analytical insights by identifying factors (say, fiscal dominance) contributing to missing the target. This can increase the costs to the government of ignoring the central bank advice. Explicit inflation targets and a credible commitment to them helps to stabilise financial markets. Gurkanyak, Sack and Swanson (2003) find that long-term forward interest rates in the US often react considerably to surprises in macroeconomic data releases and monetary policy announcements. In contrast, in the UK - which has an explicit inflation target - long-term forward interest rates demonstrate less excess sensitivity.

A stylised fact in regard to inflation is that it is highly persistent, i.e., if there is a shock that raises inflation today, inflation continues to remain high in the future and vice versa. High persistence (a unit root) indicates that inflation expectations are not well-anchored and policy efforts to reduce inflation will have to bear significant output losses. In this context, increased transparency in monetary policy formulation with priority to price stability as a key objective is expected to provide an anchor to inflation expectations and hence lower the persistence of inflation. This has an important implication: any future shock that raises inflation temporarily will not lead to a permanent rise in inflation expectations and actual inflation. Empirical evidence on persistence of inflation remains mixed. IMF (2002) suggests that inflation has become more predictable and less persistent. Levin, Natalucci and Piger (2004) find that IT anchors inflation expectations and, therefore, inflation is less persistent in IT countries than in non-IT countries. On the other hand, Cecchetti and Debelle (2004) and Marques (2004) argue that there has not been much change in persistence. Once a structural break in the mean of inflation is taken into account, there is no evidence that inflation persistence has been high in the previous decades.

In view of the recent sharp increase in international crude oil prices, this Section undertakes an assessment of their impact on economic activity. Nominal international crude oil prices have increased sharply recording new highs in the second half of 2004. The increase, however, needs to be viewed keeping in mind the sharp decline during the period 1999-2000. Notwithstanding this order of increase, prices in real terms remain less than the levels reached in 1981. An increase in oil prices affects both supply and demand in the economy. A hike in oil prices leads to an increase in the input costs for firms, reduces their profits which induces them to lower their output. As oil dependency has declined in industrialised countries over time, this supply side effect has weakened in these economies. In contrast, this effect remains significant for developing economies, in view of their increased oil dependency. On the demand side, higher oil prices reduce consumption and investment in the economy. Both supply and demand effects reinforce each other leading to a reduction in output. Consequent variations in exchange rate can add to these effects. High inflation might lead to a tightening of monetary policy, which could further reduce output. Furthermore, high oil prices transfer income to oil producers. As oil producers have a lower propensity to consume than oil consumers, global demand falls (IMF, 2004).

According to IMF (2004), a permanent increase of US $ 5 per barrel in crude oil prices is estimated to reduce world output by 0.3 per cent a year after the hike. Although the recent increase in oil prices is large enough to constitute a shock to the system, the impact is likely to prove less consequential to economic growth and inflation than in the 1970s. Inflation is estimated to increase by 60-70 basis points in major developing regions - more than three-times the increase on industrial economies. Recent research stresses that the effect on economic activity may be asymmetric - the adverse effect of an increase in oil prices is larger than the beneficial effect of an equivalent decline in oil prices. Furthermore, the beneficial effect is statistically insignificant. Studies that take such non-linearity into account suggest that a doubling of oil prices reduces output by 3.5-5 per cent in the US and by 1-2 per cent in the euro area.

To conclude this section, an assessment of the inflation record of the past half-century shows that while, in the short-run, supply shocks can lead to large changes in the headline inflation, persistent high inflation is ultimately the outcome of lax monetary policies - as witnessed during the 1970s. Monetary tightening was insufficient during the 1970s and real interest rates actually trended lower. With inflation in double digits, central banks adopted deliberate disinflation strategies beginning late 1970s. Monetary policies were tightened and industrial economies could reduce inflation significantly by the second half of the 1980s, albeit at costs of large output and employment losses. Developing countries have also been able to reduce inflation during the 1990s as fiscal consolidation and structural reforms provided flexibility to monetary policy in meeting its price stability objectives.

In view of difficulties encountered with monetary targeting and exchange rate pegged regimes, a number of central banks including emerging economies have adopted IT frameworks. Although these IT countries were able to reduce inflation or maintain low inflation during the 1990s, stylised evidence shows that even non-IT countries were successful in this endeavour. EMEs which have adopted IT face a number of constraints. This is reflected in their performance which is relatively worse than that of advanced economies. An explicit numerical target is good for anchoring inflation but it comes at a cost. If the explicit inflation target cannot be achieved it weakens the credibility of the central bank (Mohan, 2004a). Thus it may not be appropriate to formulate monetary policy based on a simplistic inflation target or a single point inflexible point target as argued by many.

Sharp variations in exchange rates can have a large influence on inflation in the short-run and this is one reason for "fear of floating". Empirical evidence suggests that, even as economies have opened up, exchange rate pass-through to domestic prices has declined during the 1990s for advanced as well as developing economies. Success of monetary policy in maintaining low and stable inflation is considered to be one of factors that explain the decline in pass-through. Overall, improvements in the institutional design of the conduct of monetary policy such as greater independence to central banks have been a key factor that led to containment of inflation during the 1990s. A key lesson is that monetary policy can contribute to growth and employment by ensuring price stability - defined as low and stable inflation. Although there is uncertainty about how economies operate and about monetary policy itself, uncertainty is no excuse for not pursuing price stability.

Since increased globalisation and competition has been one of the factors that has contributed towards containment of inflation, countries' perspective on inflation needs to be informed increasingly by world price trends, particularly in commodities of interest to them. An important consideration for reining inflationary expectations relates to the need to have clarity on price stability, effective communication, consistency in conduct of policy and transparency in explaining actions. Central banks should speak clearly to markets and listen to markets more carefully to ensure the intended objectives of policy.