Oil prices have been consistently falling since mid-2014. While the fall in the oil prices is generally regarded as positive for many businesses, it has a major influence on inflation expectations, interest rates and bond prices at the global level.
One of the most obvious effects of falling oil prices is that it brings down inflation and exerts a downward pressure on inflation expectations. Under normal economic conditions, falling inflation could be seen as positive under, but in the present circumstances with major economies struggling to meet the inflation target of around 2 percent, plunging oil prices is not good news.
Going a step further, with falling oil prices and hence inflation, the chances of an increase in the central bank interest rates become low day by day. And, central banks opting for accommodative monetary policy directly impacts bond prices, it rises.
The impact of the falling oil prices is clearly visible in the major economies around the world:
In the eurozone, recent inflation data, and the latest fall in the oil price, paint a gloomy picture. Edward Knox, currency analyst at Caxton FX said that drifting oil prices and increasing geo-political tensions have done no favours for Mario Draghi and his team.
“Monetary easing is a tool that they still have in their locker...Mounting expectations of further stimulus down the line will most likely have a negative impact on the single currency going forward.”
In the US, the Federal Reserve has two main objectives: maximum employment and 2% inflation target. The unemployment rate to 5.9 percent in October, which is close to full employment, and so it is believed that the Fed will now concentrate more in achieving the target rate of inflation.
The Fed ended its asset purchase programme last month and is expected to hike the interest rate by mid 2015. Lower oil prices and a weak global economy are likely to drive down US inflation, which will enable the Fed to keep the interest rate lower for longer. Analysts are comparing falling oil prices to an instant tax cut, which could boost overall consumption and keep the US recovery on track.
Given low price pressures, market participants' inflation expectations have fallen and FOMC members advocated that the U.S. central bank should remain attentive to a drop in such expectations.
The difference between yields on 30-year bonds and similar maturity Treasury Inflation Protected Securities, a gauge of inflation expectations known as the break-even rate, was 2.03 percentage points, the narrowest in almost three years.
In Japan, when the BoJ Governor announced additional quantitative easing measures last month, he highlighted plunging oil prices as the
crucial factor that led to the bank’s decision. Cheaper oil will drag inflation down and with Japanese economy unexpectedly falling into recession in the third quarter, the BoJ will have a tough time to get the economy on track to recovery and to hit its 2% inflation target.
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