Through the first half of the year, the price of benchmark Brent crude oil trebled to around £30 per...
Through the first half of the year, the price of benchmark Brent crude oil trebled to around £30 per barrel, the point at which an automatic increase of supply from producer countries in the OPEC cartel is supposed to click in. It did not and, after some procrastination, it was left to Saudi Arabia to go it alone to declare an extra 500,000 barrels per day output.
The move was unpopular with OPEC but greeted with relief by the commodity markets. The problem is, supply has increased but the oil price has not dropped to anywhere near the $25 level hoped for. Instead it has stuck stubbornly at around $28. With holiday demand plus unseasonably cold weather in some regions stoking demand for fuel and the usual cyclical autumn rise looming, oil prices are now a source of major concern for monetary authorities.
The US Federal Reserve left the Fed funds rate on hold after its last meeting before the summer break, but another 50 basis point (bps) rise, probably in two parts, is expected to start in August or September. The UK has similarly left the base rate unchanged at 6%, but further tightening is expected. In the euro zone, ECB president Wim Duisenberg hiked the central lending rate by 50bps in early June to put a floor under the euro, but he may now be forced to do more to ensure that the inflation target of 2% is not breached significantly over the next six months.
Rising oil prices have the effect of raising most other prices and cutting consumers' real incomes. The effect is already seen in the gap between the headline and core inflation rates, where the difference of around 1% accounts for the spike in the oil price. The monetary outlook for the US and Europe so far assumes oil would average $25 for the rest of the year. If it outstrips this and prices average out at nearer $30, another 0.2%-0.3% could be added to inflation forecasts for both this year and next, pushing the end 2001 inflation forecast 0.5% higher.
Central banks do not like reacting to these 'supply-side shocks', especially as they are likely to be only temporary. But there is still a 12-18 month period when the oil factor is a key determinant of most other indicators. Cutting interest rates to compensate for the erosion of income would simply allow a rising inflation trend to entrench. Raising rates to stamp out one contributor to inflation risks imbalances in other areas. In the UK, for example, stronger sterling would be unwelcome.
Consumers are super-sensitive to inflationary effects. Already there are indications inflation expectations are rising and wage gains are creeping up, which all translate into sharper action from monetary authorities. Global investors breathed a sigh of relief before the summer break, with a broad consensus emerging that the Fed had once again managed to ensure a soft landing for the world's leading economy.
This may already be looking a little optimistic. It has been a testing first half of the year for fund managers, but it appears the second half will be just as demanding. Many have taken measures to cut any unnecessary risk and have switched into blue chip stocks in defensive sectors before heading off for a truncated summer break. If there are a few weeks of relative inaction in the markets now, many believe it is simply the calm before the storm.
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