BlogSpot - The oil price slump and the Swiss move

Oil price slump: a panacea for EU economies?

The 50% plunge in oil price since June 2014 is a positive shock for the EU as oil is the main imported product in value terms. Kilian reminds us that the oil price drop was caused by both demand and supply factors. According to Blanchard & Arezkhi’s forecast, “word growth will gain between 0.3 and 0.7 percent in 2015.” What about Europe in times of “new mediocre”? EU growth should benefit from a distribution effect, but this positive impact will be limited according to Zachmann.

On the demand side, an IMF post explains that the EU will benefit from an increase in real income on consumption as purchasing power increases. However, Bert Scholtens highlights that the repercussions on energy cost for consumers and firms are not that clear as contracts and energy companies market power maintain prices fixed in the short run. Besides, Eurointelligence presents the results of Commerzbank study concluding that the euro depreciation mitigated the positive impact of oil drop.

Blanchard and Arezkhi add that in normal times an oil price decrease would lead to higher profits and investment thanks to a decline in production costs. But Gregorio and al.’s study conclude that this channel might be partially blocked because economies have become less oil-intensive. That is why Zachmann believe the positive consequences on employment and investment tend to be smaller and limited to sectors that are substitute to oil.

Oil prices slump resulted in downward pressure on headline and core inflation (Voxeu). However, inflation and output might be less sensitive to oil price, explains Zachmann, as inflation targeting, wage flexibility and trade-opening introduced by EU led to a decrease of the pass-through. This is good news for Blanchard and Arezkhi who believe deflation is the major threat in EU in a context of weak demand.

On the downside, Zachmann stresses that uncertainty and volatility associated with oil price swings might lead to an increase in financial risk and risk aversion. Blanchard argues that this risk is reinforced where firms and governments are indebted in dollars because of oil-exporters currency depreciation combined with financial linkages.

The consequences of the oil shock will depend on the oil future trend. Even if there is a consensus according to Jim O’Neill on the rebound of oil price in the medium term, Anatole Kaletsky sees 50$/barrel as the new ceiling of oil price and not as a floor. In this context of uncertainty, policies suggested by Blanchard and Arezkhi are raising energy taxes and using of forward guidance to anchor inflation expectations.

Taking a step back to assess the Swiss National Bank exchange rate move?

Since the Swiss National Bank (SNB) announced by surprise on January 15th the removal of the 1.20 Swiss Franc/Euro exchange rate ceiling, the Franc appreciated by 30% leading to a Euro to be worth up to 0.85 Francs (The Economist)—creating some financial panic (FTAlphaville) and disrupting financial models (more about it with these FTAlphaville and VoxEu entries).

To understand the official reason of this decision, Paul Krugman reminds us of the origin of the peg – an overvaluation of the Franc in 2011 caused by a gloomy economic context in Europe that made investors see the Swiss Franc as a safe haven currency. This led the SNB to buy huge amounts of Euros, recapitalizing at the same time the Eurozone (FT Alphaville) Being pegged to the Euro, the Franc has followed its depreciation against the Dollar this year and according to the SNB, the cap has become useless (official communiqué). However, Paul Krugman and Simon Wren-Lewis agree that this is not the right reason.

Izabella Kaminska reports one potential explanation linked with the recent oil prices’ fall – a seeking profit behavior on the currency market of the major oil traders.

However, the widespread explanation reported by Raoul Ruparel in his OpenEurope post is that the SNB has pre-empted the quantitative easing (QE) decision by the ECB. QE is expected to lead to large capital inflows into Switzerland. With the cap in place, the SNB would have been forced to massively sell Francs and buy Euros to defend the parity—at a time when it intends to reduce the size of its balance sheet because of political pressures it faces internally (FTAlphaville). David Keohane explains the SNB is concerned about potentially large losses because it is owned by private shareholders and by cantons whose revenues depend on its profits. Not abandoning the peg would have created even wider losses. Markus Brunnermeier and Harold James in a Project Syndicate entry make the parallel with the German situation in the 1960’s that bent to political criticism. For Simon Wren-Lewis, it is the perspective of a politically unsustainable inflation -though on the economic point of view this would not be a problem, the country facing a period of deflation- that forced the SNB to make its currency float.

EuroIntelligence, Edwin Truman support the peg removal, whose creation in 2011 was a mistake – it only favored Switzerland whereas Europe was in turmoil. Matthew Klein predicts positive consequences for Swiss households who were suffering from the large current surplus of their country: with the appreciation of the Franc they will be able to save less and spend more. The CEPR adds positive spillovers for neighboring economies and wishes China could emulate Switzerland. Although recognizing the end of the peg as positive because it only was a temporarily measure, Charles Wyplosz laments that the SNB has not waited before removing it: the Franc could have followed the depreciation of the Euro and thus brought inflation and growth in the country.

Paul Krugman claims this decision was a mistake as it will lead to substantial losses for banks and stock market companies (FTAlphaville) but also to deflation and recession. The decline in competitiveness will largely impede growth as the economy relies at 70% on its exports as explained by The Economist.

David Keohane reviews some alternative measures that could have been implemented instead of de-pegging: keep the cap and diversify assets. In VoxEU, Charles Wyplosz highlights the difficulty of negative interest rates for the banking sector which is predominant in Switzerland and suggests instead that the SNB should have adopted a basket peg between the Dollar and the Euro. Now the cap has been removed, he claims capital controls via taxes on inflows will be needed—a better solution than taxes on banks.

Paul Krugman regret about SNB’s loss of credibility that will affect all central banks, by revealing how difficult it is to fight against deflation. Markus Brunnermeier and Harold James suggest the de-pegging is similar to an “exit” of Switzerland from the Eurozone, demonstrating how things would happen if a member would leave the European Union.