Daily Times

FRANKFURT: The rally in oil prices could make it easier for the European Central Bank to cut stimulus from next year but will not fundamentally alter the inflation outlook and should impact policy only at the margins, economists said on Tuesday.

Having fought ultra-low inflation for years with unprecedented firepower, the ECB is set to decide in October whether to cut stimulus. It must reconcile rapid economic growth in the euro zone with persistently low prices and concerns over the deflationary impact of a stronger euro.

While a rally in oil prices LCOc1 to 26-month highs diminishes downward risks for inflation and could make it easier for policymakers to pull the trigger on a stimulus cut, it does little for core inflation, the ECB’s key focus.

“This would be a welcome development for the ECB but certainly not a game-changer as the main focus remains on underlying inflation and wage dynamics,” Frederik Ducrozet, a Senior Economist at Pictet Wealth Management, said.

“Oil prices are trading around 12 percent above ECB staff assumptions currently, which would translate into a net effect on 2018 inflation of about 0.15 percentage point using standard elasticity,” Ducrozet added. Markets expect the ECB to cut its asset purchases by a third from next year but some policymakers are wary, arguing that the firming of the euro could dampen inflation and risk unraveling years of work in reviving inflation.

The ECB’s problem is that inflation is rising much more slowly than policymakers expected even just a few months ago, suggesting that the bank’s control over prices has diminished.

Inflation is now expected to average just 1.2 percent next year, well short of the ECB’s target of almost 2 percent, suggesting that even an oil-induced increase in projections would keep the objective well out of reach. Higher oil prices could also dampen other consumption, acting as a brake on growth, analysts added.

“We have the euro strength in the pipeline, which will push down core inflation,” Commerzbank economist Joerg Kraemer said. “Oil primarily influences headline inflation in the short run and the ECB looks through such things.”

“Oil prices affect core inflation slowly but the recent strength in the euro and the increase in oil prices broadly cancel out each other as far as core inflation is concerned,” Kraemer said.

ECB inflation projections could still rise when they are updated in December, as much of the crude rally is due to fundamental factors, including rising demand, curbed production and a decline in supplies. The ECB’s latest projections were based on Brent crude at $51.8 per barrel, well below current levels around $59 per barrel, and the euro holding at around 1.18 against the dollar.

“This level around $60 (per barrel) is possible for next year; we don’t think we’ll fall back to the $40s,” Torbjoern Kjus, an oil analyst at DNB Bank, said.

“The difference compared to recent oil price rallies is that this time, it’s based on fundamentals,” Kjus said. “We can see that the shape of the forward curve, the clearest sign that inventories are drawing down, supply is lower than demand, which wasn’t the case of earlier rallies.”

Published in Daily Times, September 27^th 2017.