Higher Oil Drives ECB and Fed Even Further Apart

Last week saw the world's two most powerful central bankers diverge on the issue of inflation and policies needed to contain it.

Federal Reserve Chairman Ben Bernanke, who went in front of US lawmakers for his semi-annual grilling on the economy, said he saw only a temporary and relatively "modest increase in US consumer price inflation," while being more worried about unemployment.

Getty Images Federal Reserve Bank Chairman Ben Bernanke

On the other side of the Atlantic, European Central Bank President Jean-Claude Trichet gave the euro a big boost when he indicated his "strong vigilance" could mean euro zone rates will raise next month.

As a result Barclays Capital now expects 25 basis point hikes from the ECB in April and June, which will see a major divergence in US and European policy.

"The ECB is concerned about the effects of commodity prices on overall inflation and inflation expectations. The Fed aims to bring unemployment down, and believes that pre-crisis levels are attainable; it also focuses on core inflation, rather than overall inflation," according to Barclays Capital's analysts.

It is imperative that the policy makers maintain credibility in the face of the current oil price shock, Luca Ricci from Barcap's Strategy team said.

"One of the consequences of excessively loose fiscal and monetary policies is the limited room to expand in the face of new shocks," Ricci said.

"Therefore, it will be imperative for policymakers to retain their credibility: the experience of the 1970s shows that if policymakers lose credibility, the consequences of a supply shock can become disastrous by entrenching inflationary expectations," he added.

Global Growth in Danger

While equity markets are watching the price of crude closely, there is a very real risk of further gains for oil hitting global growth, according to Ricci.

"If large oil exporters are seriously affected, there is the potential for further large rises in oil prices, and the peak levels seen in 2008 are not unthinkable. The global economic consequences in terms of growth and inflation could be significant," he said.

"The effect of oil on economic growth can result from various factors. The main effect is on consumption via gasoline and energy prices. As consumption generally accounts for 60 percent of GDP, the effect is large," he added.

The soaring oil price could further divide the Fed and ECB, as the US focuses on rising unemployment and ECB on rising prices, Ricci said.

"As a typical supply shock, the increase in energy prices would indeed raise inflation, and decrease employment and growth, creating a policy dilemma," he said.

"Uncertainty about the path towards policy normalization was already very high. The Middle East political turmoil makes it even higher, by increasing uncertainty not only about the timing of policies, but also their direction," Ricci concluded.