16 June 2019
Joe Davis
Vanguard's Chief Economist
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Cheap Oil Driving Monetary Policy?
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Just as the Federal Reserve was bracing markets for its first interest rate hike since 2006 to head off any pickup in inflation, along came the drop in the price of oil.

And it’s been a big drop—even for an industry known for its boom-and-bust cycles. After riding high for a good part of the last decade, the price of a barrel of oil slid from more than $100 in June 2014 to less than half that by January of this year. It’s edged up a little since then, but is still down by about 50%.

That drop has helped push inflation even further below the Fed’s target rate of 2%. So will Fed policymakers be less inclined to raise rates in 2015? Not likely.

The Fed will probably look past the current dip in prices and start raising interest rates as cheaper oil can be expected to provide a boost to the economy down the road. The United States, unlike most of the world’s developed economies, has been growing at a decent clip in recent years.And it should continue to do so in 2015 with supply-driven changes in oil prices reducing energy costs. By our calculations, cheaper prices at the gas pump alone should leave about $200 billion in motorists’ pockets, which bodes well for consumer spending.¹ The price of oil will probably have to stay low for some time before we can get a good idea of how much of those savings at the pump get spent elsewhere, but a few early signs are surfacing. Americans are already spending more in restaurants and driving farther. And we’re back to buying bigger vehicles as well—sales of luxury cars, SUVs, and trucks have bumped up in recent months.

The net positive of cheap oil on the U.S. economy is one of the reasons I see the Fed sticking to its plans to raise rates in 2015. Much of the developed world, on the other hand, is in a very different place. With growth stalled and inflation worryingly low, policymakers in those regions have viewed the fall in the price of oil as a much more unwelcome development.

Europe and Japan were already marching to a disinflationary beat

The European Central Bank unveiled a quantitative easing program in January that could amount to more than 1 trillion euro. When announcing the program, ECB President Mario Draghi put some of the blame on oil for inflation drifting even further below its 2% target. But it was only one of many factors contributing to slack in an economy still reeling from the double shock of the global financial crisis and its own sovereign debt crisis. The level of economic activity in the euro area is still about 1% below its peak in 2008.

And in Japan, stagnant prices and weak growth date back much further. Inflation for the two decades ending in 2012 averaged just 0.1% a year and real GDP growth 0.8%. The introduction of “Abenomics” and its three-pronged approach of structural reforms, fiscal stimulus, and monetary easing got underway in 2013 with the aim of revitalizing the economy. But the recent drop in oil simply adds to the challenges facing Japan.

Expect rate lift off in the U.S. first

Bottom line: After a round of easing across much of the globe, monetary policy among developed nations is now likely to diverge significantly over the next several years with the Fed being the first to tighten. In the United States, the drop in the price of oil has temporarily dimmed the prospects for inflation, but the Fed will be looking at the bigger picture when determining its next move. The boost to economic growth from cheap oil and, more important, upward pressure on wages as the labor market improves(a key driver of inflation)—will likely keep the Fed on course to begin raising interest rates later this year, even if only by a modest amount.

Blog by: Joe Davis, Vanguard’s Chief Economist

© 2014 The Vanguard Group, Inc. All rights reserved. Used with permission. 

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