Oil prices add to pressure on Euro-zone rates

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Oil prices add to pressure on Euro-zone rates By David Turner and Adrienne Roberts Published: August 24 2000 10:37GMT | Last Updated: August 25 2000 09:36GMT

A turbulent week in oil markets and the still weak exchange rate of the euro have helped enhance prospects of a euro-zone interest rate rise soon.

Oil prices eased slightly in early trade on Friday, with the euro back above 90 US cents. However, with energy costs pushing euro-zone inflation above the 2.0 per cent target, the likelihood is that the European Central Bank will raise interest rates before too long - if not at its next meeting on August 31, then soon afterwards.

The benchmark Brent crude has repeatedly broken through the $31/barrel level this week, first as Hurricane Debbie was feared to be headed towards Saint Croix, the Caribbean island that produces more than half a billion barrels a day; and then as weekly stock figures from the American Petroleum Institute showed US stocks testing 24-year lows for the second time in a month.

On Friday the International Petroleum Exchange October Brent crude contract was unchanged at $30.35 in early trade, down from the week's highs.

Policymakers on both sides of the Atlantic have voiced concern about the market's volatility. After the EU (with the co-operation of the US) appealed to Opec for price moderation on Monday, President Bill Clinton added his voice, saying on Wednesday that levels needed to drop to the low-to-mid $20s a barrel to sustain economic growth. He added that Opec would suffer if high crude prices caused recession among consuming nations.

POLICY DILEMMA

For European policymakers, rising crude prices pose a particular policy dilemma.

In the short term, there is no doubt that they are inflationary. Euro-zone inflation stuck at 2.4 per cent in July, well above expectations a few weeks earlier, with energy the main culprit (consumer prices excluding energy rose by only 1.4 per cent, well below the ECB's target ceiling of 2.0 per cent). With the ECB allowing its marginal bid rate to rise by almost a quarter of a percentage point at this Tuesday's weekly funds auction, expectations are that the benchmark minimum bid rate will rise above 4.25 per cent either later this month or in September.

The longer term effects of the high oil price are, however, far more uncertain.

There appears little danger at this stage that energy costs will strangle the incipient euro-zone recovery, despite evidence this week of faltering business confidence in Germany, the area's biggest economy. Even if the benchmark rate rises 0.5 percentage points it is unlikely to be high enough to bring Europe's recovery grinding to a halt.

Nevertheless, someone has to pay for the higher cost of oil.

One possibility is that consumers will carry the burden, as companies take advantage of stronger domestic demand to pass on higher costs. The alternative is that companies will absorb the higher costs themselves.

The story so far shows a mixture between the two. Euro-zone industrial producer prices rose by 5.6 per cent in the year to June, but consumer prices by just 2.4 per cent.

The striking differential between these figures could simply be storing up consumer price inflation for the future. The European Commission forecast in March that euro-zone inflation would average 1.8 per cent this year, within the ECB's 2 per cent threshold. But the commission said last week that this forecast was now in doubt. Its calculations assumed an average oil price of $24.2 a barrel.

Forecasts for the coming month range from as low as $26 to a high as $31. A $1 change in the price of oil is generally reckoned to mean a change in euro-zone consumer price inflation of between 0.06 and 0.1 percentage points.

However, Robert Prior-Wondesforde, European economist at HSBC, says the existing level of pass-through into consumer prices holds little danger of feeding into bigger wage demands and hence an inflationary spiral.

Many of the biggest euro-zone wage deals, already agreed this spring, last for two years. These include the agreement negotiated between the huge IG Metall union and Germany's manufacturing employers' federation. By the time they run out, memories of any oil-induced inflation in late 2000 should have faded.

The corrollary is that companies will take on much of the burden of the cost of oil. If profits fall, it could hit business investment. Lorenzo Codogno, European economist at Bank of America, notes: "It is difficult to believe that oil will have no effect on economic growth, given that the price has been so strong for so long". But he does not expect it to cause a recession. "This could well shave a bit off growth in the next two or three years", he says.

Chris Wright, chief economist at Barclays, is among those who think the euro-zone will be able to steer a steady course between the threats of inflation and deflation, aided by strong global demand. He notes: "Companies will be able to absorb costs through higher profits and so not pass costs onto consumers." Euro-zone investment grew 7.6 per cent at an annualised rate in the first quarter of the year, according to Dresdner Kleinwort Benson.

If Opec allows the price of oil to fall again, the effect on growth could end up being modest. A return to Opec's declared target range of $22-$28 for a basket of seven crudes, could make the recent rise in prices look no more than a substantial ripple

http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3WXHS9ACC&live=true&tagid=ZZZGXV4R00C

-- Martin Thompson (mthom1927@aol.com), August 25, 2000


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