Fuel costs: free money comes at a high price

Ceteris paribus (all else equal) is the magic tool economists use to investigate or analyze the influence of one variable on another. For example, with ceteris paribus I can say that if I have the ball and all Ajax players do not move, I will score. That work. It doesn't matter that everything else never stays the same. The assumption makes it easy to formulate or test a theory, such as whether I am indeed hitting the ball against the ropes. 

I was reminded of those magic words when I tapped €2,32 per liter of petrol on Tuesday evening. The oil price is now about the same as in 2008. But then a liter of petrol really cost €1,15 to €1,20, about half what we pay today. How is that possible?

Yes, excise duties have increased every year, which explains part of the difference. But it doesn't explain the entire increase. Part of the explanation also lies in the value of the euro. In 2008, one euro cost almost US $1,60. Today, the exchange rate has fallen to $1,09. And that is very important when we talk about fuel prices, because Europe gets oil from abroad. We pay that oil in US dollars. The lower the exchange rate, so the fewer dollars it takes for one euro, the weaker our currency is and the more we need for a barrel of oil. Suppose the exchange rate is 1, that is, for a euro you get for a dollar. If a barrel of oil costs $125, the price in euros is $125. But if the euro weakens and the rate is no longer 1 but € 0,50, then the same barrel of black gold suddenly costs € 250 while the price in dollars has remained unchanged! 

Fed and ECB policy
The fact that the euro has fallen in value since then is partly due to the difference in policies of the Fed and the European Central Bank (ECB). Ceteris paribus – there it is – if interest rates in the US are higher or are expected to rise, the dollar becomes more attractive (you get more interest on it). The demand for dollars rises, the supply of euros falls and the price between the two, the exchange rate, changes in favor of the dollar. In terms of EUR/USD rate: it is falling. 

Between 2012 and 2014, both the Fed and the ECB pursued the same policy: official interest rates at 0% and started printing money to buy government bonds. The euro/dollar exchange rate hardly changed during that time, fluctuating between $1,3 and $1,4 per euro. In 2015, the Fed started raising interest rates. The price promptly dropped to around $1,10 and has largely remained around that level to this day. In 2022, the Fed is preparing to raise interest rates again and the bank will stop buying government bonds one of these days. The ECB will just continue with it and an interest rate hike is far from being on the agenda. 

The lesson of a strong currency
You could say that if the ECB, like the Fed, had previously raised interest rates and started to cut or stop buying, the euro/dollar exchange rate would have been significantly higher than $1,09 today. Maybe 20% higher, if not more. In other words, the oil that the euro countries buy would be 20% or more cheaper than it is now, expressed in euros. We had certainly noticed that at the pump. 

The lesson is that a strong currency is preferable to a weak currency. Not just because oil is getting cheaper. A strong currency demonstrably contributes to the strength, strength and resilience of an economy. It is not without reason that the strong euro countries, such as the Netherlands, Germany and Austria, are all countries with a history of very strong coins, the guilder, the mark and the schilling. Likewise, it is no coincidence that the weak euro countries, such as Italy or Greece, are countries with a history of very weak national currencies. For the euro area as a whole, in the medium and long term, it is better not to forget that lesson and to adapt policy accordingly. Instead of cheering every time a penny drops off the exchange rate. Because that means higher costs, for example at the pump. The lesson, in short, is that free money comes at a very high price in the long run. 

Edin Mujagic

Edin Mujagić is an economist and manager at Beleggingsfonds Hoofbosch. He focuses on global central banks, and in his blogs he writes mainly about developments in interest rates and inflation. He has also written several books.

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