Case Study 2: Supply shocks: oil prices and inflation [40 marks] Figure 2 shows the dramatic increase in oil prices after 2002, rising from $20 a barrel to over $130 a barrel in late 2008, before falling rapidly back to $40 a barrel during the financial crash. Thereafter, oil prices rose to around $100 a barrel before settling into a more normal range of $50-$70, though with brief periods above and below. More recently, the price of oil forward contracts became negative for the first time in April 2020 as the global economy entered a lockdown due to the COVID-19 pandemic and jumped to almost $120 a barrel in February 2022 due to the Russian invasion of Ukraine. Figure 2: Global price of WTI 2002-2022 FRED - Gicbilsrise of wil credo a Bren Figure 3 shows UK consumer price inflation since 2002. If oil price shocks lead to inflation, why did so little inflation materialise when oil prices were $130 a barrel? Figure 3: UK Consumer Price Index 2002-2022 FRED - Consumer Forlet Idek Hamenterd Prices: Total Al items for the vilist Kingdom SHEE The tripling of oil prices during 2003-07 was potentially as dramatic a supply shock as the world had experienced when OPEC first flexed its muscles in 1973. Yet the effects were very different. In the 1970, oil price rises led to a decade of high inflation and output stagnation. In the 2000s, economies continued to boom until the financial crash, and inflation remained muted. Why was the impact of higher oil prices so modest? First, the increase took place steadily rather than in a step jump. Having longer to adjust, purchasers of oil had more time to switch to alternative energy sources. Second, the pressure of globalisation encouraged importing countries to absorb the oil price increase rather than attempt to pass it on in higher prices. Workers accepted reductions in real wages, and firms accepted a reduction in profit margins. Central banks argued that inflation targeting had affected the outcome in a helpful way. Firms and workers understood that attempts to pass on higher energy costs into higher wages and output prices would simply induce the central bank to raise interest rates dramatically causing a recession that would be more painful thanabsorbing the oil price rise. By anchoring inflation expectations, monetary policy encouraged adjustment in rea wages and real profit margins. The financial crash imposed a sharp fall in aggregate demand and initiated rapid contraction. World demand and world commodity prices fell for a bit. But by 2009, China had returned to 10 per cent growth, and the price of oil and other commodities began rising again. Significant growth rates were being seen in many emerging markets. Upward pressure on world commodity prices was more intense than ever. The financial crash of 2008 helps explain why oil prices briefly dipped to $40 a barrel, but Chinese growth quickly resumed, and oil prices reached $100 a barrel again. Inflation still failed to emerge on a significant scale. Figure 3 shows that in the immediate aftermath of the crash, during which sterling had fallen sharply and import prices had risen, the Bank of England was temporarily prepared to tolerate inflation of up to 5 per cent, despite an inflation target of 2.5 per cent, rather than raise UK interest rates and choke off the fragile output recovery. This shows flexible inflation targeting in action. The Bank of England was credible in saying that it would steadily reduce inflation, as the chart above shows: during 2012-16, UK inflation fell steadily until the Brexit referendum caused a sharp fall in the UK exchange rate and a consequent rise in import prices. The more credible the central bank on inflation control in the medium run, the more it can pursue output stabilisation in the short run without triggering an increase in inflation expectations. Conversely, central banks whose credibility is fragile can take few risks with the level of current inflation in case they set off a damaging rise in inflation expectations. There is no clearer demonstration of this proposition than the history of Germany's central bank, the Deutsche Bundesbank, before the formation of the euro. The Bundesbank was known to be the most vigorous defender of low inflation in Europe. Yet when crises occurred, the Bundesbank often cut interest rates by more than other central banks. However, a year later, when the crisis was over, the Bundesbank was often the only central bank that had raised interest rates back to their original level again. That is how we would like central banks to behave. Questions 1. Explain why inflation remained low in the UK despite the rise in oil prices as globalisation took place. [10 marks] 2. Explain how the financial crash helped to curb the rise in inflation. [10 marks] 3. With reference to the case study, how successful has the Bank of England been in controlling inflation in the UK? [10 marks] 4. What conclusions can you draw about the current situation in the UK with regards to inflation, monetary and fiscal policy? [10 marks]