Abstract

The surge in commodity prices has boosted headline inflation across Europe. Analysis in this chapter focuses on the risks to inflation. Though some rigidities remain, improved labor market flexibility, the weakening economy, and strong monetary policy credibility should help limit second-round effects in the advanced economies. The risks of spillovers of price pressures to a broad range of consumption goods are greater in the emerging economies, where food and fuel account for a substantial share of consumption.

The surge in commodity prices has boosted headline inflation across Europe. Analysis in this chapter focuses on the risks to inflation. Though some rigidities remain, improved labor market flexibility, the weakening economy, and strong monetary policy credibility should help limit second-round effects in the advanced economies. The risks of spillovers of price pressures to a broad range of consumption goods are greater in the emerging economies, where food and fuel account for a substantial share of consumption.

Commodity prices have surged in recent years. Oil prices have doubled since the end of 2006. Global food and metals prices have also risen sharply (Figure 11). The current boom in commodities has also lasted longer than most historical episodes. With food and energy prices accounting for a significant share of consumption, the commodity price increases have boosted headline inflation across Europe (Figure 12). For some emerging economies, the rise in food and energy prices is adding to existing price pressures from overheating and convergence-related factors.

Figure 11.
Figure 11.

Metals, Food, and Oil Prices in Real Terms, 1960:Q1–2008:Q2 1/

(Index, 1990=100)

Sources: Bloomberg L.P.; U.S. Department of Energy; U.S. Department of Agriculture; and IMF staff calculations.1/ Prices in U.S. dollars, deflated by U.S.consumer price index. Metals comprise copper, lead, and zinc.
Figure 12.
Figure 12.

Advanced and Emerging Europe: Contribution of Food and Fuel Price Increases to Headline Inflation

Food Price Contribution to Inflation

(Percentage points)

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Fuel Price Contribution to Inflation

(Percentage points)

Source: IMF, World Economic Outlook.

Large increases in commodity prices present a difficult challenge for policymakers. A major concern is that these increases have been so broad based and sizable that they may trigger a rise in inflation expectations and demands for higher wages, which would put upward pressure on all prices.6 At the same time, commodity price rises depress real growth for the commodity-importing countries.

The commodity price boom raises the following key questions, which are addressed in this chapter:

  • What caused the increase in food and oil prices? How long will the boom last?

  • What are the effects of the commodity price increase on core and headline inflation? Do these effects differ among countries in Europe? What are the risks to inflation?

  • What factors do monetary policymakers need to take into account when judging the appropriate policy response? Are the fiscal actions taken by various European governments in response to the rise in commodity prices helpful?

Commodity Price Boom: Causes and Prospects7

The rise in oil prices is driven both by strong demand and by low spare capacity.8 Strong global growth in recent years has pushed up demand for commodities. In particular, the growth acceleration in emerging and developing economies has played a key role since it has been commodity intensive. In addition, oil demand in many countries has been relatively insulated from rising prices through various policy measures, often at a significant fiscal cost.9 On the supply side, markets have been vulnerable to disruptions, as spare capacity is at relatively low levels and the cost of developing new oil fields has risen. In the long term, oil price prospects will depend on how quickly capacity constraints ease and on the responsiveness of demand to high prices. However, in real terms, fuel prices will remain significantly above the low levels of the early 2000s. Futures markets suggest that oil prices in U.S. dollars are expected to remain around their current spot level.

Food prices have been pushed up by a combination of rising demand and weather-related supply shocks. Strong consumption growth, especially in the emerging economies, contributed to the increase in food prices. Soaring demand for corn and vegetable oils from biofuel producers has been an additional factor. On the supply side, droughts in 2006 and 2007 damaged grain crops. Higher energy costs and rising fertilizer prices have also boosted food production and distribution costs. Finally, the imposition of more restrictive food trade policies in a number of countries has caused a temporary overshooting of prices. The estimated contribution of each of these factors to the global rise in prices for some major foods varies considerably (Figure 13). Looking forward, the resolution of weather-related supply disruptions and the removal of trade restrictions will lead to some easing of prices. Nonetheless, price pressures from high energy prices and rising biofuel production will remain.

Figure 13.
Figure 13.

Contributors to Price Increases of Major Foods

(12-month average percent change, 2006:H1–2008:H1)

To summarize, prices of commodities relative to other goods are likely to stay at a higher level. The issue facing policymakers is how to facilitate a smooth adjustment of relative prices and ensure that the rise in headline inflation remains a temporary phenomenon. The following section looks at the implications of the commodity price boom for inflation prospects in Europe.

Effect of Commodity Price Increases on Inflation in the Advanced Economies

Higher international oil and food prices raise domestic inflation directly, by affecting the energy and food components of the consumer price index (CPI). Most of the increase in headline inflation in advanced Europe over the last year has been due to this “first-round” effect. Meanwhile, core inflation (a measure of inflation excluding food and energy) has remained subdued so far (Figure 14.).

Figure 14.
Figure 14.

Headline and Core Inflation, January 2004–August 2008

(Percent)

Source: Eurostat.1/ Harmonized index of consumer price inflation (excluding energy, food, alcohol, and tobacco).

There could also be “second-round effects” on inflation, if workers demand higher wages to compensate for the loss in their purchasing power and if firms pass on the higher costs of production to the price of other goods. There are concerns that the current period of persistently high commodity price inflation may unhinge inflation expectations and trigger demands for higher wages, which would affect all prices.

Turning to the data, inflation expectations have increased both in the United Kingdom and in the euro area, although the July rate hike in the euro area seems to have reversed the upward trend in inflation expectations (Figure 15.)10 Labor costs in the euro area have also edged up over the past year but remain relatively contained (Figure 16.)

Figure 15.
Figure 15.

Inflation Expectations in the Euro Area and the United Kingdom, 2001–08

(Percent)

Sources: Bloomberg L.P.; European Central Bank; Haver Analytics; and IMF staff calculations and forecasts.1/ European Commission survey of consumers; price trends over the next 12 months; balance statistic.
Figure 16.
Figure 16.

Labor Costs in the Euro Area, 2000:Q4–2008:Q2

(Year on year, percent)

Sources: Eurostat; European Central Bank; Haver Analytics; and IMF staff calculations.

To assess the likelihood that rising commodity prices could cause broader price pressures, the historical pass-through of commodity prices to core inflation is analyzed, using a vector autoregression (VAR) model for a set of advanced economies (Box 4). The results of the analysis suggest the following:

Pass-Through of Commodity Price Shocks to Inflation in Some Advanced European Economies

To evaluate the impact on inflation of commodity price shocks and separate it from other potential inflationary pressures, such as economic growth and monetary policy, a five-variable structural vector autoregressive (SVAR) model is used. The domestic price response of commodity price shocks for 12 European countries is assessed, as well as the changes over time in the nature and size of those effects.1 The baseline VAR includes the following variables: the nominal price of oil and food, different measures of domestic inflation (food, energy, core, and headline), a measure of economic activity, and a measure of the monetary stance.2

Fluctuations in crude oil prices are found to be no longer as important as they were 20 to 30 years ago. Estimates of the impact of a 10 percentage point oil price shock on domestic energy inflation, core inflation, and headline inflation are reported for two different sample periods, pre- and post-1986 (first table).3 The break date chosen is one commonly identified in the literature, and each subperiod contains two large oil shock episodes (Blanchard and Gali, 2007). First-round effects persist, as part of the increase in oil prices is mechanically reflected in the energy component of the consumer price index (CPI). However, and more important, the impact on headline inflation is more subdued after 1986, and the shock does not last as long. This evidence is consistent with Blanchard and Gali’s (2007) hypothesis that the macroeconomic effects of oil price shocks have become more negligible in advanced economies in recent years, owing to a combination of better monetary policies, more flexible wages, and lower oil dependency.

Inflation Response to an Oil Price Shock

(Peak response within the first six months, percentage points)

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Source: IMF staff estimates.Note: Impulse responses to a 10 percentage point shock to oil price inflation. Results are reported only for countries for which responses were significant at the 90 percent level.

“n.s.” means not significant.

Contrary to the findings on oil price shocks, the impact of international food price shocks has been more pronounced in recent years. Domestic food inflation shifted up more and remained positive for a protracted period after 1996.4 The impact on headline inflation follows mechanically, though it is less than proportional, while core inflation remains relatively unaffected, except for Germany and Sweden (second table).

A possible explanation for the more intense pass-through of food prices in the past decade lies in the major institutional and policy changes experienced by European countries in the 1990s. The MacSharry reform—the first major reform of the Common Agricultural policy (CAP), launched in 19925 and implemented over the subsequent four years—replaced market support by direct income support. This reform, accompanied by compulsory set-asides of arable land, led to a rapid decline in supply and in stocks. In addition, following negotiations for the Uruguay Round and the creation of the World Trade Organization in 1995, market support from the CAP (the intervention price and the associated border measures that determined import tariffs and export refunds) was significantly reduced, thus curtailing incentives for supply surpluses and reducing the space for buffering future shocks.

Inflation Response to a World Food Price Shock

(Peak response within the first six months, percentage points)

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Source: IMF staff estimates.Notes: Impulse responses to a 10 percentage point increase shock to world food price inflation. Results are reported only for countries for which responses were significant at the 90 percent level.

“n.s.” means not significant.

Note: The main authors of this box are Chadi Abdallah, Rodolfo Luzio, and Boriana Yontcheva. See Yontcheva, Abdallah, and Luzio (forthcoming) for a detailed description of the analytical work.

1 Austria, Belgium, Denmark, Finland, France, Germany, Greece, Italy, Norway, Portugal, Sweden, and the United Kingdom.2 Data were stationary in first differences. The dollar price of oil was used rather than the real price of oil, to avoid dividing by an endogenous variable, the GDP deflator. Data come from the International Financial Statistics database and cover the period from January 1970 to December 2007.3 Oil shocks are identified by assuming that only oil price shocks can influence oil prices in the long run; only oil and food shocks are allowed to influence international food prices in the long run. A vertical, long-run Philips curve is assumed to give two restrictions, which state that monetary policy shocks and aggregate demand shocks have no long-run impact on industrial production. Additionally, monetary policy shocks are not allowed to have a contemporaneous effect on real economic activity.4 A structural break in the international food price series seems to have occurred in 1996, coinciding with a rise in U.S. demand for ethanol and increased corn imports by developing countries, in particular China and Mexico (European Commission, 2008).5 The pre-1992 CAP guaranteed a minimum price to producers and imposed a system of variable tariffs, as well as a system of storage and disposal of surplus domestic production. This system was extremely “successful” in expanding agricultural production, leading to sizable supply surpluses and consequent costly budget expenditures.
  • The pass-through from international fuel prices to domestic headline and core inflation has diminished considerably since the 1970s. As discussed in Blanchard and Gali (2007), the muted response to oil price shocks in recent years can be explained by a combination of better monetary policy, more flexible wages, and a lower oil intensity of production in the advanced economies.

  • The pass-through from international to domestic food prices seems to have strengthened somewhat since the mid-1990s, following a number of reforms that increased competition in agricultural production. Nonetheless, the pass-through from food price shocks to core inflation remains relatively low for most countries.

To summarize, in contrast to the 1970s, energy price increases have not had a significant effect on core inflation over the last two decades for the advanced economies. The effect of food price rises on core inflation has also been relatively small. However, one should keep in mind that the cumulative commodity price increases over the last four years have been higher than anything experienced in the previous two decades, so the actual pass-through going forward may still surprise on the upside.

To complement this analysis, the inflation outlook for the euro area and the risks around it are evaluated using econometric analysis and model simulations based on more recent data (Box 5). The econometric forecasting models take into account recent developments in the domestic and global economy that can influence inflation. The forecasts suggest that inflation would start to fall gradually toward the inflation target as commodity price growth subsides and economic growth slows. However, the risks around the central forecast are substantial. A forward-looking structural model of the economy also implies that the combination of a relatively tight monetary policy stance, slowing economic growth, and deteriorating financial conditions will gradually dampen inflationary pressures.

Inflation Outlook in the Euro Area

This box uses two approaches to form a view about the inflation outlook and the risks around it. First, a set of inflation forecasts is produced from a large number of empirical forecasting models.1 The advantage of this approach is that it captures the effects of numerous macroeconomic variables on the inflation process; the disadvantage is that it is backward looking. Second, a small structural model of the euro area is used to project inflation.2 This approach has the advantages of being forward looking, accounting for simultaneity of the shocks, and incorporating the ECB’s policy response.

The results from the set of inflation-forecasting models suggest that inflation will decline over the next two years to the ECB’s target of “below but close to 2 percent” (first figure). The distribution of the inflation forecasts implies substantial risks around the central forecast. In that regard, the interaction between wages and inflation expectations is key, as Granger causality tests suggest they do affect each other.

The results from the structural model also portray a benign inflation outlook. Because of the tight financial conditions and the expected weakening of aggregate demand, inflation is projected to decline below 2 percent by the end of 2009 (second figure). The model results therefore support the ECB’s view that, following the increase in the policy rate by 25 basis points to 4.25 percent in July, “the monetary policy stance … will contribute to achieving our objective” (see ECB, 2008c).

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Euro Area: Econometric Model Forecasts of Inflation (Starting June 2008)

(Year on year, percent)

Sources: Eurostat; and IMF staff estimates.

On balance, the results suggest that the combination of a tighter monetary stance, slowing growth, and tighter overall financial conditions is gradually dampening the inflationary forces. However, there are risks to the inflation outlook. On the downside, the real economy may slow even more sharply than currently envisaged. On the upside, with the labor market sill somewhat tight, there are some risks of second-round effects. Going forward, economic and labor market developments will be of particular importance.

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Euro Area: Inflation Forecast with Structural Model

(Percent)

Sources: ECB; and IMF staff estimates.1/ Based on the harmonized index of consumer prices.
Note: The main author of this box is Emil Stavrev.1 For the methodology and further details on the forecasting framework, see Stavrev (2006).2 The model has three behavioral equations—aggregate demand, aggregate supply (inflation equation), and a monetary policy reaction function. Important elements of the model are the central bank’s credibility and forward-looking nature of market participants. Additional features are the estimation of model-consistent potential output and natural interest rates. The model is estimated using Bayesian techniques, with quarterly data from the first quarter of 1993 to the second quarter of 2008.

Effect of Commodity Price Increases on Inflation in the Emerging Economies11

The rise in commodity prices has had an even larger impact on headline inflation in the emerging economies in Europe, due to the larger share of food and fuel in their consumption baskets. To assess the effect of international commodity price changes on domestic inflation, a VAR model is used.12 The results suggest that increases in world fuel prices have a significant impact on domestic energy inflation in most countries (Table 3). The pass-through is very rapid—the peak effect is typically reached in six months (or less) after the increase in world prices.

Table 3.

Response of Domestic Food and Energy Inflation to International Commodity Price Inflation Shocks 1/

(Percentage points)

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Source: IMF staff calculations.

Results are reported only for countries for which responses are significant at 95 percent level. Size of the shocks: 10 percentage point increase in international food and oil price inflation.

Maximum response within 12 months.

“n.s.” means not significant.

Shocks to international food price inflation also have a significant impact on domestic food inflation for many emerging economies (Table 3). However, variance decompositions suggest that, while 30 percent of the variability of domestic fuel prices can be attributed to global price shocks, only 10 percent of the volatility in domestic food prices can be attributed to changes in global food prices. Therefore, domestic factors—such as local weather conditions, rising wages and transportation costs, increasing local demand for higher-value-added food items driven by income convergence, and continuing trade integration—are key drivers of local food prices.13

Complementing this analysis, a panel regression was estimated to examine the contribution of various factors to changes in domestic food inflation.14 The results show that, over the past year, three factors explain most of the increase in domestic food price inflation: the international food price shocks, disruptions in local agricultural production due to bad weather, and inflation inertia. Real effective exchange rate appreciations had a moderating effect on inflation in a number of countries.

There are tentative signs that rising commodity prices are causing broader price pressures in emerging Europe. Over the last year, core inflation has edged up, inflation expectations have risen, and unit labor costs have increased in a number of economies (Figures 1719).15 Of course, these developments may also be caused by overheating pressures and tight labor markets. To isolate the effect of commodity price changes on core inflation from other factors, the responses of core inflation to changes in domestic food and fuel prices are examined in the VAR framework.16 The results imply that some emerging economies are susceptible to second-round effects. The spillover from domestic food inflation shocks to domestic core inflation is positive and significant in eight countries, while the spillover from fuel price increases to core inflation is significant in five countries (Table 4).

Figure 17.
Figure 17.

Core Inflation 1/

(12-month percent change)

Sources: Eurostat; and national authorities.1/ Baltics: Estonia, Latvia, and Lithuania; other New Member States: the Czech Republic, Hungary, Poland, the Slovak Republic, Bulgaria, Romania, and Slovenia; CIS: Moldova and Ukraine; SEE: Albania, Croatia, FYR Macedonia, Serbia, and Turkey.
Figure 18.
Figure 18.

Inflation Expectations 12 Months Ahead, 2005–08

(Percent)

Sources: National authorities; and Consensus Economics.
Figure 19.
Figure 19.

Changes in Unit Labor Costs, 2005–07 1/

(Percent)

Source: OECD; and Haver Analytics.1/ Baltics: Estonia, Latvia, and Lithuania. Other New Member States: Bulgaria, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, and Slovenia. Excludes Bulgaria and Slovenia in the fourth quarter of 2007 and Poland, Romania, and Slovenia in the first quarter of 2008.
Table 4.

Response of Core Inflation to Shocks to Domestic Food and Energy Price Inflation 1/

(Percentage points)

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Source: IMF staff calculations.

Results are reported only for countries for which responses are significant at 95 percent level. Size of the shock: 10 percentage point increase in domestic food and energy price inflation.

Maximum response within 12 months.

“n.s.” means not significant.

Panel estimates also suggest possible spillovers from commodity price developments to core inflation.17 Over the past year, domestic food inflation has been the most important contributing factor to the rise in core inflation in emerging Europe. Other factors, such as inflation inertia, real effective exchange rate changes, and price convergence, have played a smaller role.

Policy Responses

Policymakers have taken various actions to mitigate the negative impact of high food and fuel prices on consumers (Table 5). A number of countries have tightened monetary policy, while others have changed their tax and tariff policies. In response to public pressure, some governments have considered cutting gasoline taxes. Model simulations suggest, however, that such measures would be counterproductive (Box 6). Generally, fiscal and structural policies should focus on easing supply bottlenecks, providing the right incentives to producers and consumers, and ensuring a well-functioning social safety net for the most vulnerable. The following sections discuss some factors that monetary policymakers need to consider when faced with commodity price shocks.

Table 5.

Emerging and Developing Europe: Policy Responses to Inflation Pressures1/

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Sources: IMF Country Reports and Selected Issues; area department desks; national central bank inflation reports and websites; Economy Watch; and news articles.

This table was contributed by Inci Otker-Robe.

1 = Reserve requirements, 2 = capital control, 3 = credit controls.

1 = Higher tax on energy; 2 = higher tax or restrictions on exports; 3 = lower value-added tax, sales taxes on selected items (food, energy, etc); 4 = higher value-added tax, other taxes on selected items; 5 = increased subsidies (explicit or implicit) on agriculture/energy items; 6 = social safety nets; 7 = increase in minimum wage; 8 = lower import tariffs; 9 = price controls or moral suasion to keep prices low; 10 = increase in administered prices.

Initially the target horizon and inflation forecast; subsequently, the target level adjusted upward.

Government inflation forecast adjusted upward.

The Effects of Cutting Taxes on Gasoline

Some governments have considered cutting taxes on gasoline to mitigate the impact of the oil price increase on consumers. While there is a case for using social policy to protect the most vulnerable from the rise in commodity prices, an across-the-board cut in gasoline taxes is not a good policy proposal for three reasons. First, it is not targeted. Second, demand for oil will be higher than it would have been in the absence of policy intervention, and thus the price of oil will be higher. Finally, a cut in gasoline taxes may have to be financed by raising other taxes, likely with negative effects on economic growth.

The economic impact of a gasoline tax reduction is assessed using an extended version of the IMF Global Economy Model (GEM) that explicitly incorporates production and trade in oil (Elekdag and others, 2008; and Lalonde and Muir, 2008).

The response of oil prices, output, consumption, and investment in the euro area to a 10 percentage point reduction in ad valorem gasoline taxes is shown in the figure. The reduction of gasoline taxes is assumed to be financed by an increase in taxes on labor income, which have significant disincentive effects on labor supply. The gasoline tax cut slows the process of substitution away from energy consumption. Oil prices rise relative to the baseline, offsetting some of the effect of the lower gasoline taxes for the consumer. The oil trade balance deteriorates, and the real exchange rate depreciates to stimulate exports and crowd out imports. The increase in labor taxes reduces aggregate employment and investment. Consumption declines, owing both to the negative wealth effect of higher oil prices and to the reduction in productive capacity and real income.

Instead of reducing gasoline or food taxes, a better approach is to develop a well-targeted social safety net. From an efficiency standpoint, it is better to pass on the full commodity price increase to consumers since that will encourage producers to raise supply and consumers to adjust demand. From a fairness standpoint, the benefits of reducing consumption tax rates accrue disproportionately to the higher-income households, since they consume a larger absolute amount of all goods (including energy and food). At the same time, it is the poorest households that are least able to cope with the price increases, given the large share of food in their consumption baskets. A policy of targeted transfers would ameliorate the impact of higher commodity prices on the most vulnerable without creating distortions or imposing an undue burden on the budget.

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Euro Area: Ten Percent Reduction in Gasoline Tax Rates

(Deviation from baseline, in percent)

Source: Simulation based on the model in Elekdag and others (2008).

Note: The main authors of this box are Dora Iakova, Douglas Laxton, and Dirk Muir.

The Appropriate Monetary Policy Response to Commodity Price Increases . . .

Sharp increases in commodity prices present a difficult challenge for monetary policymakers in the commodity-importing countries. Higher input costs reduce real growth, while putting upward pressure on inflation. Setting an interest rate path that helps the economy adjust smoothly is a delicate balancing act. As the experience of the 1970s shows, policy mistakes can have serious negative economic consequences.18 The magnitude of the economic effects and the appropriate monetary policy response will depend, among other factors, on the presence of nominal and real rigidities in the economy, on the drivers of the oil price increase, and on the degree of policy credibility.

. . . Depends on the Flexibility of Labor Markets, . . .

How can producers respond to rising nonwage costs? In the short run, they can accept a reduction in profits. However, capital markets reward firms with higher rates of return, so lowering profit margins could be only a temporary solution. In the medium term, firms should either raise productivity or reduce real wages.19 In case of a downward rigidity of wages, the monetary authorities have to raise interest rates to prevent a wage-price spiral.

Model simulations illustrate the effects of temporary real wage resistance after a rise in the price of oil (Figure 20).20 In the baseline scenario (the solid line), wages adjust promptly in response to higher oil prices triggered by a disruption in oil supply. In the second scenario (the dotted line), real wages are assumed to remain unchanged for two years before gradually coming down to the new equilibrium. In the latter case, there is a secondary spike in inflation (a second-round effect) as firms increase prices to be able to pay the higher wages. Interest rates need to rise by more and stay higher longer to bring inflation back to target. The tight monetary policy will result in greater output loss than in the scenario of flexible labor markets. In summary, if real wages adjust quickly, monetary policymakers can accommodate the commodity price increase, minimizing the impact on the real economy. If not, monetary policy will need to remain tight to prevent second-round effects.

Figure 20.
Figure 20.

Wage Resistance and a Policy Error

(Percentage point deviation from baseline)

Source: IMF, Global Economy Model simulations.Notes: Solid line = energy sector supply shock; dotted line = supply shock with temporary wage resistance; and dashed line = temporary wage resistance and a policy error.

Structural reforms have improved the flexibility of labor markets in Europe over the past two decades. Employment rates have been on a trend rise in a number of countries. In addition, the globalization of the labor markets, and especially the greater mobility of labor within the European Union, has helped keep wage growth broadly in line with productivity. Therefore, wage adjustment should be smoother than in the 1970s. However, based on various measures of labor market rigidities, many advanced European countries still rank among the economies with less flexible labor markets, and some still have wage indexation. This fact explains the close watch that policymakers are keeping on wage developments in Europe.

. . . on the Credibility and Experience of Monetary Policymakers, . . .

The appropriate monetary policy response would also depend on the degree of policy credibility. The higher the inflation-fighting credibility of the central bank, the more likely it is that inflation expectations will remain contained, and the easier it will be to bring inflation down. Several central banks in Europe, including the European Central Bank, have tightened policy over the last year to signal commitment to their inflation targets. For some emerging economies, which are showing signs of overheating and where policymakers’ credibility is still being established, monetary policy may have to tighten further.

After the experience of the 1970s, monetary policymakers have come to realize that a rise in commodity prices driven by a reduction in supply reduces the productive capacity of the economy. This leads to a temporary moderation of real growth rates, and attempts to stimulate the economy to maintain high growth rates only intensify the upward pressure on inflation. The effect of such a policy error is illustrated in Figure 20 (the dashed line). In this simulation, policymakers continue to target a high growth rate, without realizing that the level of potential output has declined. In this case, the initial monetary policy stance is overly expansionary, and the spike in inflation is higher and more persistent than in the baseline case.21

In practice, estimating the reduction in potential output associated with the energy price shock is subject to methodological challenges and data problems. IMF staff analysis suggests that the 2007–08 increase in oil prices could reduce the level of potential output in the European economies by about ½ to ¾ percentage point (Box 7). To avoid overheating, policymakers, especially in some emerging economies, should resist the temptation to maintain the exceptionally high growth rates seen in recent years. This is of particular importance at present because the current commodity price boom, unlike the 1970s boom, is driven by a combination of oil supply constraints and excess demand. The following section explains why the source of the energy imbalance matters.

Impact of High Oil Prices on Potential Output in Europe

A key consideration for policymakers in their response to oil price shocks is the extent to which such shocks affect the supply capacity of the economy. Even though oil intensity of production has fallen in Europe in recent decades (first figure), a panel VAR, production function estimates, and simulations of an empirical growth model for net oil-importing European countries indicate that the 2007–08 increase in oil prices could reduce the level of potential output by about ½ to ¾ percent.

Time-Series Evidence

The medium-term impact of oil prices changes on real output in advanced economies is estimated through a panel VAR.1 The model is estimated separately for the periods 1960–83 and 1984–2007, following Blanchard and Gali (2007), who find the impact of oil price on U.S. output to be considerably larger in the first period. The results for the period 1960–83 show that an increase in the oil price of one standard deviation ($12.20) leads to a decline in real GDP of 1.3 percent in the medium term. However, an increase in the oil price of one standard deviation in the period 1984–2007 ($15.40) leads to a decline in real GDP of only about 0.25 percent (second figure). Therefore, the negative impact of oil on output has been considerably smaller in recent decades (and is not statistically significant). These estimates suggest that the 2007–08 oil price increase could reduce real GDP by 0.8 percent in the medium term, in the worst case scenario.

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Advanced European Oil-Importing Economies: Oil Intensity of Production, 1971–2005

(Net imports of oil barrels per thousand of real U.S. dollar GDP)

Sources: IMF, World Economic Outlook; and IMF staff calculations.
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Advanced European Oil-Importing Economies: Impulse Response Functions and Response of Real GDP to Changes in the Oil Price, 1960–83 and 1984–2007

Source: IMF staff calculations.

Evidence from a Production Function and a Cross-Country Panel

Estimates from a production function for all European economies with positive net imports of oil suggest that the recent increase in the price of oil ($36 a barrel in 2008) could reduce real GDP growth by an annual average of 0.2 percentage point in the next four years, equally in advanced and emerging economies (first column of table).2 The results are sensitive to the assumption for the oil price elasticity. The table includes the midpoint of a range of possible estimates.3

Estimates from an econometric growth model suggest that the recent oil price increase will reduce growth in oil-importing European economies by an annual average of 0.3 percentage point over the medium term. More specifically, the higher oil price projected for 2006–104 could slow annual growth during this period by 0.2 percentage point in advanced oil-importing European economies and by 0.4 percentage point in emerging economies.5 These estimates are derived from a panel regression model, with fixed country effects, covering 77 oil-importing economies (European and non-European) from 1965 to 2005. The dependent variable is the average per capita real GDP growth. The list of independent variables includes the standard growth determinants found in the literature. In addition, the regression includes the price of oil, deflated by the U.S. consumer price index, and its interaction with the lagged net imports of oil barrels per thousands of real dollar GDP. The results are presented in the second column of the table.6

Impact of Oil Price on Potential Real GDP Growth in Oil-Importing European Economies

(Based on the WEO assumption for oil prices during 2008–10)

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Source: IMF staff calculations.
Note: The main author of this box is Athanasios Vamvakidis.1 The sample includes advanced European economies with positive net imports of oil for the period 1960–2007. Emerging European economies are excluded because their available GDP time series are relatively short for this type of analysis.2 Technology is assumed to be Cobb-Douglas with three factors, capital, labor, and oil—and with constant returns to scale. The capital stock for advanced European economies is estimated using the perpetual inventory method. For emerging economies, the capital stock estimates are taken from the April 2008 Regional Economic Outlook: Europe, Chapter 3. The oil input in production is assumed to be equal to each country’s oil trade deficit in barrels. The income share of labor is as in the April 2008 Regional Economic Outlook: Europe, Chapter 3, or from Barro and Sala-i-Martin (2004). The oil income share is calculated as the ratio of each country’s oil trade deficit in U.S. dollars divided by GDP in U.S. dollars. Based on the constant-returns-to-scale assumption, the capital income share is one minus the income shares of labor and oil.3 The estimates are the midpoint of two extreme scenarios: at one extreme, the country does not change its net imports of oil barrels in response to the increase in the price of oil, in which case its net oil import–to-GDP ratio increases proportionally to the oil price increase; at the other extreme, the country keeps its GDP share of net oil imports constant, in which case its imports of oil barrels adjust fully to the oil price increase over the medium term.4 The oil price is assumed to average $89 during 2006–10, based on the latest WEO global assumptions—an increase of $55 in nominal terms, or 129 percent in real terms, compared with the previous five-year period.5 The estimates should be considered as the upper limit of a possible range, which will be falling as countries adjust to the price shock by reducing the oil intensity of their production.6 The estimated model is the following (heteroscedasticity-consistent t-statistics in parentheses): –3.69(–4.89) per capita GDP – 4.74 (–2.96) age dependency ratio + 0.16 (4.64) investment / GDP + 0.03 (4.60) trade / GDP + 0.29(3.27) net imports of oil barrels per thousand of real dollar GDP – 0.004 (–0.27) real price of oil – 0.006(–3.82) net imports of oil barrels per thousand of real dollar GDP * real price of oil + 0.73 (3.96) time trend; adj. R2 0.49. The inclusion of fixed country effects is justified by the Hausman test. The price of oil is statistically significant only as an interaction with the oil intensity of production.

. . . and on the Source of Oil Price Pressures

Does the source of the energy market imbalance—excess global demand or limited supply—matter for the effects of the oil price shock on inflation and the real economy? To answer this question, two simulations are conducted using the IMF’s Global Economy Model, calibrated on the euro area. In the first one, the increase in oil prices is driven by a reduction in oil supply capacity. In the second, productivity increases in emerging economies raise global demand and the price of oil. The results illustrate the difference in economic outcomes, depending on the source of the imbalance, and the appropriate policy responses (Box 8).

Does the Driver of the Energy Imbalance Matter?

To evaluate the role of different drivers of the energy imbalance, this box conducts two simulations using the IMF’s Global Economy Model (GEM).1 In the first one, the increase in oil prices is driven by a reduction in oil supply capacity. In the second, productivity increases in emerging economies raise global demand and the price of oil.

In the first simulation, a permanent increase in the price of energy of about 50 percent is generated by restricting the supply of oil. The increase in the price of energy (an input in production) causes a permanent decline in real output of 1 percentage point, a reduction in the capital stock, a decline in the marginal product of labor, and, therefore, a reduction in the real wage (the solid line in the figure). Consumer price inflation increases modestly on impact and then returns to target within two years. Here, it is assumed that households accept without resistance the decline in the real wage. Therefore, the increase in energy costs is offset by lower real wages, and there are no second-round effects affecting consumer price inflation. Under these assumptions, the monetary authorities can afford to accommodate the temporary increase in headline inflation, and real interest rates remain broadly unchanged.

F1lev20c
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Alternative Drivers of Energy Price Increases

(Percentage point deviation from baseline)

Source: IMF, Global Economy Model simulations.Note: Solid line: energy sector supply shock; dotted line: rest-of-the-world tradable sector productivity shock.

In the second simulation, a similar increase in the price of energy is achieved by assuming rising tradable sector productivity growth in the rest of the world. This captures the idea that fast growth in emerging Asia has been important in driving up energy demand and energy prices. Rising productivity in the tradable sector abroad will lower prices of tradable goods imported by the euro area. The positive terms of trade effect of falling non-energy prices will offset the negative impact of higher energy prices on domestic output growth. In addition, rising incomes abroad will increase demand for euro area exports. The euro area exchange rate will depreciate (a Balassa-Samuelson effect), further stimulating exports. In this case, the decline in real GDP is only temporary. As exports pick up and the terms of trade improve, GDP recovers, rising above the baseline in the long run.2

In contrast to the first simulation, the rise of inflation is very persistent in the second simulation. This phenomenon reflects the recovery in real wages and increased demand pressures, driven by rising export demand and the wealth effect from an improvement in the terms of trade. In this scenario, interest rates must remain elevated for an extended period to contain the inflationary pressures.

Note: The main author of this box is Dora Iakova.1 The GEM is a large macroeconomic model, augmented with an energy sector. A two-country version of the model is constructed, representing the euro area and the rest of the world. The euro area is a net importer of energy. Energy is produced with a fixed factor (land), labor, and capital, and can be used both as an intermediate input in production and as a final consumption good. For a general description of the GEM, see Laxton and Pesenti (2003). Hunt (2006) describes the incorporation of energy into the GEM. This simulation is based on the euro area calibration of the model used in Bebee and Hunt (2008).2 The precise magnitude of the positive effect will depend on the direct trade linkages between the euro area and the fast-growing emerging economies. A number of other factors will also affect the economic outcome in reality. The policy of energy price controls in some large emerging markets does not allow the higher international price of energy to mitigate demand in these economies. This situation would keep oil prices higher than in the absence of such a policy. The policy of fixing the exchange rate to the dollar that some emerging markets and oil exporters follow could also delay economic adjustment and reduce the magnitude of the effects described above.

If energy prices rise because of a reduction in oil supply, there is an unambiguous reduction in the productive potential of the world economy. As long as labor markets are flexible and workers accept a one-off reduction in their real wages to match the decline in labor productivity, relative prices will adjust quickly and the rise in inflation will be temporary. However, if the energy price increase is driven by rising productivity in emerging markets, the long-run effects will be different. The euro area will experience rising demand for exports and an increase in the relative price of its exports, which would offset, at least to some extent, the negative output effects of the oil price increase. Rising global demand will trigger a rise in domestic wages and exert upward pressure on inflation. In the second scenario, interest rates need to remain elevated for an extended period to bring inflation down.

During the current boom, both supply and demand factors have contributed to the rise in energy prices. The above analysis suggests that monetary policy authorities in Europe need to be even more vigilant about the inflationary consequences of commodity price increases if higher productivity in the emerging economies is an important cause of the rise in energy prices. If policymakers treat the commodity price surge as driven only by a reduction in oil supply capacity, they will amplify inflationary pressures.

Policy Conclusions

Will the boom in commodity prices lead to a sustained increase in inflation in Europe? For advanced economies, the empirical findings of this chapter give ground for cautious optimism. In contrast to the 1970s, energy price shocks over the last two decades have not had a significant effect on core inflation. Though rigidities remain, improved labor market flexibility, strong monetary policy credibility, and the weakening economy should help limit second-round effects. However, the pass-through to core inflation may still surprise on the upside. When choosing the optimal monetary policy stance, policymakers in advanced economies will have to continue to balance carefully the upside risks to the inflation outlook against the disinflationary impact of decelerating activity.

In emerging economies, where food accounts for up to half of the consumption basket, concurrent large increases in food prices have a greater potential to affect inflation perceptions and feed into core inflation. Therefore, in the countries where the commodity price shocks are coming on top of existing price pressures from overheating, and where monetary policy credibility is still being established, a tighter monetary policy stance may be justified. In the countries where economic activity is decelerating, but inflation remains high, policymakers should resist pressure to maintain the recent high growth rates. In some emerging economies with fixed exchange rates, maintaining a tight fiscal policy stance may be warranted to prevent second-round effects.

In both advanced and emerging economies, fiscal and structural policies should aim to ease supply bottlenecks and provide the right incentives to producers and consumers. Universal subsidies and commodity tax reductions may entail fiscal costs—with the benefits accruing primarily to the higher-income households—and provide distorted price signals, which could ultimately reinforce global price pressures. Recognizing the drawbacks of this type of measures, last June EU member countries confirmed the 2005 Manchester agreement—which called for avoiding the use of distorting fiscal and other policies—and expressed support for temporary and well-targeted actions.

Some countries have imposed export restrictions or price caps to keep food prices low. Such policies should be avoided as they discourage farmers from expanding agricultural production in response to rising world prices. In contrast, tariff reductions can help by reducing trade distortions and mitigating price increases. Also, countries with restrictions on the use of land for agriculture should consider taking measures to ease them. Finally, domestic competition could be promoted to increase supply and ease price pressures.

Note: The main authors of this chapter are Dora Iakova, Edda Zoli, Chadi Abdallah, Rodolfo Luzio, Emil Stavrev, Athanasios Vamvakidis, and Boriana Yontcheva.

6

See Ball and Mankiw (1995) and Sims (2003) for a discussion of the possible effects of large relative price changes on inflation.

7

This section is based on analysis presented in Chapter 3 of the October World Economic Outlook (IMF, 2008a).

8

Financial speculation has been seen by some as an important factor driving up commodity prices. Analysis conducted by IMF staff does not find support for this view.

9

See IMF (2008e).

10

The break-even expected inflation rates—derived from bond prices—for the United Kingdom have also stabilized since late August.

11

The underpinning analytical work for this section is presented in Zoli (forthcoming).

12

The model includes the following variables: world fuel and food inflation, the 12-month change in the industrial production index as a measure of economic activity, domestic energy inflation, domestic food inflation, core inflation, the 3-month money market rate, and the 12-month change in the nominal effective exchange rate. The model is a “near” VAR as international food and fuel prices depend only on their lagged values, and not on domestic variables. Block-exogeneity tests confirm the validity of this assumption. The model is estimated on monthly data from the late 1990s to March 2008. Impulse responses are obtained using the Cholesky decomposition, with the variables ordered as listed above. For Ukraine, a dummy is included among the explanatory variables to account for the spike in energy import prices from Russia in 2006–07.

13

For net food exporters, surging international food prices increase domestic demand, which adds to inflation pressures.

14

The panel regression, estimated with quarterly data, is the following: Annual domestic food price inflation = 5.9 + 0.18 * Annual domestic food price inflationt–4 – 0.10 * Deviation of agriculture value added from a trendt–1 –0.09 * Price level relative to EU-15 price levelt–1 + 0.14 * International food price inflation + 0.14 * Annual change in the VAT rate – 0.34 * Annual change in nominal effective exchange ratet–1 – 0.09 * Money market ratet–6 + 0.3 * Annual percent change in per capita income.

15

Core inflation is defined as headline inflation excluding the food and energy components. Admittedly, in some emerging economies, these excluded items make up a large portion of the consumption basket.

16

Since domestic factors have a significant effect on domestic food and fuel prices for the emerging economies (with international factors playing only a partial role), the focus is on the impact of domestic food and fuel prices on core inflation, while accounting for common driving factors such as demand pressures and exchange rate changes.

17

Annual core inflation = 4.8 + 0.44 * Annual core inflationt –4+ 0.28 * GDP gapt–1 – 0.07 * Price level relative to EU-15 price levelt–1 + 0.21 * Annual domestic food price inflationt–1 + 0.07 * Annual domestic energy price inflationt–1+ 0.25 * Annual change in the VAT rate – 0.11 * Annual change in nominal effective exchange ratet–1– 0.08 * Money market ratet–6.

18

Commodity prices rose steeply in the 1970s against a background of already-rising inflation and low interest rates. Wage earners, organized in powerful unions, tried to preserve their purchasing power and demanded higher wages, which led to second-round effects on inflation. In response to the commodity price shock, initially monetary policymakers focused on maintaining high growth rates and continued easing monetary policy, further increasing inflation. High inflation became entrenched in many countries. Eventually, inflation was brought down by substantial, sustained monetary policy tightening, at the cost of a significant output loss and high unemployment.

19

Theoretically, when the price of an input in the production function (energy) increases, the marginal product of labor declines, implying that real wages will need to adjust accordingly. Energy-intensive capital becomes obsolete; therefore, the capital stock also declines. Overall, an increase in commodity prices is equivalent to a negative productivity shock, and, therefore, potential output declines.

20

The model is the IMF’s Global Economy Model, augmented with energy prices, and calibrated for the euro area. Details on the model calibration and simulations are available from Dora Iakova.

21

In the simulation, policymakers understand their mistake after two years and correct their policy response. Since the model assumes rational expectations, anchored on the inflation target, there is no substantial cost in terms of lost output. In the real world, there is an added complication—once inflation expectations move above the target and the central bank credibility diminishes, it becomes very costly to reduce inflation.

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