Hike interest rate to handle crude oil crisis, says IMF

New Delhi, March 22 | Updated: Mar 23 2006, 05:30am hrs
An International Monetary Fund (IMF) working paper on crude oil crisis has made a strong case for tightening monetary policy and increasing interest rates, to bring demand in line with supply and contain inflationary effect of high oil prices.

The paper titled World Crude Oil Markets: Monetary Policy and the Recent Oil Shock by Noureddine Krichene stressed that tightening of monetary policy was necessary to achieve greater energy substitution and savings during the demand shock period. It made the suggestions while highlighting the risk of a world economic contraction and inflation that could be caused by high oil prices.

The oil markets remained highly volatile during 2005, and prices followed a persistent upward trend in the midst of rising world demand for oil, stimulated by exceptionally low interest rates and a rigid oil supply, the paper said.

Although the oil demand is price-inelastic, it is significantly influenced by the level of economic activity. The demand, it added, is negatively influenced by interest rates and nominal effective exchange rate (NEER).

The oil supply is also highly price inelastic though, it is strongly co-related with the natural gas production. The paper attributed persistent oil volatility to a combination of factors including low price, high-income elasticity, and rigid supply.

While analysing the relationship between monetary policy and oil prices, the paper suggested that an oil demand shock, caused by record low interest rates, led to exorbitant price increases witnessed in 2004-05. It further added that the monetary policy, conducted through changes in interest rates and monetary aggregates, did have a significant and protracted effect on aggregate demand for goods and services as well as on asset prices such as exchange rates, housing prices, and stock prices.

It further pointed out that stimulated by low interest rates and a depreciating US dollar, demand for oil has expanded faster than the supply. Given the short-run price inelasticity of both oil demand and supply, the equilibrium is obtained through a large scale increase in oil prices, it said.

The IMF paper also drew a distinction between the supply shock and demand shock. It added that contrary to a supply shock, where the change in oil prices results in a pure relative price change that will help bring about stronger energy substitution and savings, in a demand shock most asset prices move upwards with a general increase in the price level.

Consequently, it concluded, the relative change in oil prices become less noticeable, and therefore, the energy substitution and energy savings effect could be less important than under a supply shock.