price shock

Loan growth is losing pace and $10bn short-term capital has left Turkey since the start of its new interest rate policy in December, central bank governor Durmus Yilmaz said Friday. Despite this, the current account deficit – one of the principal targets of the measures – will continue to rise in the first quarter due to base effects. Mr Yilmaz added he did not foresee a change in policy when his governorship ends in April.

The statements add up to declaration of success – but there was a caveat. Oil prices, driven higher by events in Libya, created a “new situation”, Mr Yilmaz admitted. Turkey’s rate-cutting, reserve-requirement-raising policy has so far been possible thanks to falling inflation and fairly high unemployment. (Rate cuts in an inflationary environment would have been far more dangerous.) If oil prices were to remain high, they would create an inflation risk that might constrain Turkey’s monetary plans. For now, as long as Saudi Arabia and its oil reserves stay out of the current turmoil, many believe the oil price shock will be short-lived.

Each of the last five major downturns in global economic activity has been immediately preceded by a major spike in oil prices. Sometimes (e.g. in the 1970s and in 1990), the surge in oil prices has been due to supply restrictions, triggered by Opec or by war in the Middle East. Other times (e.g. in 2008), it has been due to rapid growth in the demand for oil.

But in both cases the contractionary effects of higher energy prices have eventually proven too much for the world economy to shrug off. With the global average price of oil having moved above $100 per barrel in recent days – about 33 per cent higher than the price last summer – it is natural to fear that this latest oil shock may be enough to kill the global economic recovery. But oil prices would have to rise much further, and persist for much longer, for these fears to be justified.

With global oil supply already impacted by Libyan shut-downs, the threat of an oil shock has moved well beyond the realms of the theoretical. According to recent reports, about half of Libya’s 1.6m barrels per day of oil output have been knocked out, and this has been enough to trigger a rise of about $14 per barrel in the spot price of oil in the past week.

Total Libyan oil production is less than 2 per cent of the world total, and it is of course most unlikely to be lost on a permanent basis. According to

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The era in which central bankers could apparently do no wrong ended emphatically in 2008. Since then, they have attracted plenty of criticism as they have adopted a succession of unconventional policies to stabilise the world economy and financial system. But now they could be facing an even more difficult problem – a commodity price shock which simultaneously raises headline inflation while also slowing the recovery from recession. The recent orthodoxy among central bankers is that they should ignore commodity price shocks because they are quickly self-correcting. Headline inflation will rise, but core inflation will not, so interest rates can be left unchanged. But does this orthodoxy need to be revised?

The orthodoxy about headline and core inflation is held most firmly by the US Fed. Yesterday’s speech by Ben Bernanke re-affirmed this set of beliefs in notably strong terms. He acknowledged that the economy is recovering (and his tone was a little more optimistic on that front than the most recent FOMC minutes), but he emphasised that core inflation would remain very subdued because unemployment and spare capacity are still very high. Therefore core inflation, and wage inflation, remain very subdued. The rise in oil and food prices, which are likely to impact the headline inflation rate considerably in the next few months, were given very short shrift.

This, then, is the orthodoxy. Spare capacity (usually measured by the output gap) determines the core inflation rate. Increases in commodity prices can, from time to time, lead to

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