September 26, 2018 / 11:28 AM / 3 months ago

Commentary: Third time lucky for ECB on rates as oil eyes $100

LONDON (Reuters) - The European Central Bank’s interest rate hikes of 2008 and 2011 were perhaps the biggest policy errors in recent central banking history. With $100 oil coming into view again, the last thing the ECB wants is a repeat.

A drill rig is pictured at the BP America Dracorex Gas Unit well site in Lufkin, Texas, U.S., June 13, 2018. REUTERS/Jonathan Bachman

Twice bitten, thrice shy.

The price of Brent crude oil this week hit $82.55 a barrel, the highest in almost four years. It’s up 40 percent over the past year, an inflationary red flag the ECB would normally find difficult to ignore.

Also this week, ECB President Mario Draghi told the European Parliament that an acceleration in underlying inflation in the euro zone was “relatively vigorous” and expressed confidence that a pick-up in wage growth would continue.

Add all that together, you might think the ECB would quite readily backtrack on its pledge to keep interest rates at historically rock-bottom levels “through the summer” of next year, and deliver an inflation-cooling rate hike or two earlier.

Not this time.

If anything, an oil price shock of crude breaking above $100 a barrel could tempt the current incumbents in Frankfurt’s Eurotower to ease policy, or at the very least go looser for longer, rather than tighten.

Firstly, the current spike in oil is more a function of supply constraints than surging demand. U.S. sanctions on OPEC members Venezuela and Iran have hit production there, while spare capacity from OPEC and its allies remains historically low, according to Nomura.

The world economy, led by the United States, is growing at a robust and steady clip. But the balance of risks to growth, from trade wars to rising U.S. interest rates, is tilted to the downside. Slowing economic growth will cap oil demand.

Secondly, oil prices notoriously overshoot, accelerating in the run-up to cyclical peaks and troughs. This means they rise far higher, and fall much further, than commentators thought possible just a few months earlier.

Thirdly, signs of oil remaining high, say above $100 for an extended period, could squeeze corporate profits and potentially force companies to lay off workers. Rising unemployment, in what is already a fractious and dangerous political environment, would surely be viewed with alarm in Frankfurt.

In short, there’s a case to be made that this would be “bad” inflation, not “good” inflation. Certainly not the time for a re-run of 2008 or 2011.

(Graphic: Oil and ECB rate hikes: reut.rs/2N1TFRi)

The ECB raised rates in July 2008 as oil hit a record high $147/barrel, having doubled over the previous year. This was right in the midst of the global credit crunch: Bear Stearns had been rescued only a few months before, and Lehman Brothers would collapse a few weeks later.

In 2011 oil was again above $100 and the ECB raised rates not once but twice, just as the euro zone debt crisis was bubbling up: Greece and Ireland had already received bailout packages, and bond yields in Spain and Italy were ballooning to levels that would eventually prompt Draghi’s “whatever it takes” intervention a year later.

Policymakers will be more cautious this time around, not least because inflation, although at target, is lower than it was then. Headline inflation is running at 2 percent, whereas it nudged 4 percent in 2008 and 3 percent in 2011.

The ECB expects its 2.6 trillion euro ($3.1 trillion) bond purchase scheme to end at the close of this year and keep rates low “through” the summer of next. The guidance on rates is vague enough to give the ECB a lot of leeway.

It could raise rates in September next year, or December, or not at all, and still justifiably have kept its pledge.

The opinions expressed here are those of the author, a columnist for Reuters. 

Further reading:

"Vigorous" inflation recovery still needs low rates: ECB's Draghi

ECB not planning to speed up normalisation, Praet says

Oil market hears echoes of 2007/8

Looming loss of Iranian crude is latest in a long line of disruptions

($1 = 0.8513 euros)

Editing by Dale Hudson

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