The Europeans have reported that inflation has risen to 4% on an annualized basis. In historical terms –think the 1970s– this isn’t much. It is, however, the largest increase since the creation of the European Central Bank (ECB). The ECB has a different mandate than the US Federal Reserve System. The Fed is charged with managing the country’s economic well-being across a broad spectrum, including controlling inflation and facilitating growth.
It can use its judgment as to what it should focus on. The ECB, by contrast, has a single mandate: controlling inflation. That may change at some point, but right now, that mandate applies –and that means that the ECB will fight inflation regardless of the consequence. The general consensus is thus that the ECB will raise interest rates.
That may help control inflation, but it also will strengthen the euro and weaken the dollar as money flows into European banks. As the dollar weakens, the price of commodities –particularly oil– will continue to rise. A stronger euro may mitigate some of the effects of that rise. But as the price of oil rises, so will Europe’s and the rest of the world’s cost of living. As the Fed pursues a policy of maintaining liquidity to avoid a recession, the ECB will go in the opposite direction. The result is a dangerous cycle.
The real issue isn’t Fed or ECB policy or synchronizing them. That isn’t going to happen. The real issue is whether anyone is going to intervene in this cycle before massive imbalances in the system move the global economy into massive pieces that it is difficult to conceive of any particular act making a difference, save for one actor and one action. That would be Saudi Arabia indicating a commitment to increase oil production dramatically. That announcement would shift the momentum of oil prices and begin to release some of the pressure on the global system.
On the surface, it might appear that Saudis would want the highest price possible. But in reality, they benefit more from having the highest sustainable price over the long run. A massive global recession is going to cut demand for oil. Furthermore, the 1970s taught that extremely high oil prices generate increased oil exploration and production. It took years to bring this oil online, but when it finally did come online in the 1980s and 1990s the Saudis fell victim to excruciatingly low prices.
The Saudis remember that well. They are in the game for the long haul –or at least as long as their oil lasts– because they have no other game to play. They love high oil prices, but it is inimical to their interest to have oil prices so high that it undermines demand while energizing investment in competitive supplies and technologies. If the Saudis learned anything from the last cycle, it is that they shouldn’t push things too hard.
We focus on the Saudis because no other single actor has the potential for undertaking action that might low oil prices, relieving the price pressure in Europe, allowing the dollar to strengthen and hopefully –but by no means certainly– stabilizing the international economic system. We were not impressed by the subprime crisis alone, but if the subprime crisis coupled with extreme commodity prices is another matter.
The Saudi oil conference that ended June 22nd had no effect and the Saudis didn’t expect it to. It was a gesture designed to placate politicians around the world. As oil moves towards $150 a barrel, the system is cracking under the strain. It if cracks, the Saudis will not be the winners in the long run. The Americans and Europeans are not going to manage the crisis and it is not clear that even the Saudis can. But right now, it is Riyadh’s move. They are not particularly sensitive to outside pressure, but they do remember the mistakes they made in the 1970s. If the Saudis make no move, then the Bank of International Settlement may turn out to be right in its warnings.
By: N. Peter Kramer
