Excluding a handful of oil exporters or countries where sharply depreciating currencies or domestic factors caused inflation to soar, developing country inflation has fallen quite significantly over the past few months and is expected this year to be at its lowest level since 2009 (Figure 1). The broad-based pattern of slowing inflation has been largely driven by plunging oil prices, albeit to varying degrees reflecting in particular exchange rate developments, the extent of fuel subsidies and other price regulations.
This disinflationary impact of lower oil prices should mostly be temporary, dissipating by the end of 2016, but the coincident fall in core inflation and relatively weak growth in some emerging economies have led a number of central banks to ease policy in advance of an expected tightening of US monetary policy later this year (Figure 2). These recent trends beg the question of how developing country central banks should respond to lower oil prices. What are the different trade-offs and challenges for monetary authorities in oil-exporting and oil-importing countries? Some pointers are provided in a recent World Bank Policy Research Note analyzing the impact of plunging oil prices.
A first consideration for central banks pondering their response to lower oil prices is to assess the persistence of their impact on inflation. Given that energy is a key intermediate good, its price impact could be widespread across sectors and over time, especially in the presence of sticky price and wage formation. However, the impact of oil price changes on headline inflation tends to peak rapidly and to remain muted on core inflation—contrasting, for instance, with the more lasting effect of food price shocks or currency depreciations. From this perspective, central banks should not overreact to the one-off effect of lower oil prices, especially in the face of a weakening currency, unless medium-term expectations are negatively affected as well. This might be the case in a relatively limited number of developing countries where low or negative inflation could make monetary policy more sensitive to any downside risks to price stability.
A second aspect to consider is the expected impact of lower oil prices on output. Optimal monetary policy rules tend to dictate a forceful response to aggregate demand shocks pushing growth and inflation in the same direction, but a more neutral one to supply shocks having diverging effects on output and prices. The response of monetary policy to oil price changes could therefore be vastly different depending on the source of the shock and its impact on aggregate demand and potential output levels.
Among oil-exporting countries, central banks are balancing negative growth effects with the need to maintain stable inflation and investor confidence in the face of significant currency pressures. Orderly exchange rate depreciation can help these countries adjust to a negative terms-of-trade shock and limit the effect on aggregate demand, but disorderly currency movements can put significant strain on balance sheets and lead to a challenging combination of above-target inflation, declining activity and rising financial pressures. Monetary policy that stabilizes the real exchange rate or the domestic-currency price of exports is generally seen as delivering higher welfare gains and stability among oil exporting countries than that strictly targeting consumer price inflation.
Among oil-importing developing countries, declining inflation, current account improvements and continued favorable global financing conditions have provided central banks additional room to maneuver in the short term. But lower oil prices should eventually support stronger aggregate demand, while pressures associated with a strengthening U.S. dollar and the upcoming U.S. interest rate tightening cycle point to the need for a certain level of caution.
Central banks will continue to face conflicting trends and policy tradeoffs in coming months. They should focus on those having the greatest risks of seeing inflation moving away from medium term policy objectives in either direction. The decline of oil prices is one among many more factors and considerations affecting their policy stance at present.
This article was first published by the World Bank’s Prospects for Development blog. Publication does not imply endorsement of views by the World Economic Forum.
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Authors: Ayhan Kose is Director of the World Bank Group’s Development Prospects Group. Marc is a consultant for the Global Macroeconomics Team in DECPG.
Image: A worker walks down the stairs of an oil tank at Turkey’s Mediterranean port of Ceyhan, which is run by state-owned Petroleum Pipeline Corporation (BOTAS). REUTERS/Umit Bektas.