Oil-monetary-policy

‘FORWARD GUIDANCE’ – HOW MONETARY POLICY-MAKERS SHOULD REACT TO AN OIL WINDFALL

Countries that discover oil should commit to cutting their interest rates and pursuing a loose monetary policy until the oil revenue begins to come in – at which point they should raise interest rates and tighten monetary policy. That is the central finding of research by Samuel Wills, presented at the Royal Economic Society’s 2013 annual conference.

His study seeks to find a better policy than that carried out by Azerbaijan since its recent discovery of oil. Between its discovery in 2002 and the completion of the Baku-Tbilisi-Ceyhan pipeline in 2005, Azerbaijan’s inflation and unemployment rose dramatically.

The author notes that there is often a significant period of time between the discovery of oil and the start of the much anticipated ‘oil boom’. This is because contracts need to be signed, wells need to be drilled and pipelines need to be laid.

While government spending does not usually rise before production begins, domestic prices can begin to rise in anticipation of future demand. This rise in prices makes imports relatively cheaper and exports relatively more expensive, resulting in a possible recession before the oil wells begin to pump.

The research finds that the best way of overcoming a recession after an oil discovery is for the central bank to commit to loosening policy immediately before the windfall hits – then tightening again when the windfall begins. The loosening will boost output before the windfall begins, while the tightening will smooth the adjustment of the economy to the new oil income.

Together, these commitments help to delay the appreciation of the currency until government spending begins. By this point, the research claims, government spending can take up the slack in the economy left by higher imports and lower exports.

Such commitment is not without precedent. The Board of Governors of the US Federal Reserve has recently made use of a similar tool, ‘forward guidance’. In their December 2012 statement, the governors committed to keeping interest rates low until the unemployment rate fell to 6.5%. The author concludes:

‘Similarly forward-looking policy, in publicly committing to monetary policy actions when oil production starts, may have major benefits for oil exporters around the world’.

More…

Baku, the capital city of Azerbaijan, is being transformed. Oil is coursing through a recently built pipeline to the Mediterranean, bringing wealth that is making the city shine like the flickering walls of the new landmark, Flame Towers, which is to open this spring.

But Azerbaijan’s oil has not come without issues. Between a major increase in their proven reserves in 2002, and the completion of the Baku-Tbilisi-Ceyhan pipeline in 2005, Azerbaijan saw both inflation and unemployment rise.

Recent research by Samuel Wills at the University of Oxford finds that oil discoveries like Azerbaijan’s may actually cause a recession in the months immediately following, and this cannot be addressed using standard monetary policy.

People usually associate oil discoveries with booming economies. But there is often a significant period of time between the discovery of oil and the start of the boom. This is because contracts need to be signed, wells need to be drilled and pipelines need to be laid, like that in Azerbaijan. As another case in point, oil was discovered in Ghana’s offshore Jubilee field in 2007. But production did not begin for another three years, until December 2010.

During the time between discovery and spending, there can be a period of recession. While government spending does not usually rise before production begins, domestic prices can begin to rise immediately in anticipation of future demand, appreciating the terms of trade. This appreciation makes imports relatively cheaper and exports relatively more expensive, both of which conspire to reduce domestic output before the oil wells begin to pump.

Standard monetary rules aren’t able to overcome this recession. A standard loosening of monetary policy to control the recession will just raise domestic prices further, exacerbating the initial problem. Alternatively, a currency peg will see all the adjustment to the new level of output happen through domestic prices and output, because the exchange rate cannot act as a ‘shock absorber’ in easing the economy’s adjustment to its new level of wealth. Something else is needed.

This research finds that the best way of overcoming a recession after an oil discovery is for the central bank to commit to loosening policy immediately before the windfall hits, and tightening again when the windfall begins. The loosening will boost output before the windfall begins, and the tightening will smooth the adjustment of the economy to the new oil income.

Together, they delay the appreciation of the currency until government spending begins. Thus, government spending can take up the slack in the economy left by higher imports and lower exports.

Such commitment is not without precedent. The Board of Governors of the US Federal Reserve has recently made use of a similar tool, ‘forward guidance’. In their December 2012 statement, the Fed governors committed to keeping interest rates low until the unemployment rate fell to 6.5%. Similarly forward looking policy, in publicly committing to monetary policy actions when oil production starts, may have major benefits for oil exporters around the world.

ENDS


Notes for editors:

‘Optimal monetary responses to oil discoveries’ by Samuel Wills is currently a working paper in the University of Oxford’s OxCarre working paper series.

This work is part of a programme of research on monetary policy in resource exporters at the University of Oxford’s Centre for the Analysis of Resource Rich Economies.

Contact:


Samuel Wills: +44 (0) 7735 589150 (samuel.wills@economics.ox.ac.uk)
RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

Page Options