INTRODUCTION

The 5th of June 2014 European Central Bank (ECB) governing council meeting made the following monetary policy resolutions:
  1. "The interest rate on the main refinancing operations of the Eurosystem will be decreased by 10 basis points to 0.15%, starting from the operation to be settled on 11 June 2014
  2. The interest rate on the marginal lending facility will be decreased by 35 basis points to 0.40%, with effect from 11 June 2014.
  3. The interest rate on the deposit facility will be decreased by 10 basis points to -0.10%, with effect from 11 June 2014."
As highlighted in the article All Eyes on the 5 June European Central Bank Meeting, these measures are meant to address the low inflation and economic growth problems being faced by the euro area.

The question and answer segment of the press conference provided some interesting views. In response to the question on the strength of the Euro and the possibility of seeing the euro fall back to the initial level against the dollar at 1.17 the ECB president Mario Draghi had this to say, “the exchange rate is not a policy target, but it's very important for price stability and growth.” He also went further saying, “First, the first half of the last three years, it was mostly the declines in the price of oil and food and perhaps some other commodities that have accounted for something like 75%, 80% of the difference between inflation then and inflation now. Then, in the last year, it was the prices in dollar terms haven't moved much; it was the exchange rate that has accounted for the decline in inflation.”

The objective of this article is to investigate the extent to which the exchange rate and crude oil prices influence the inflation rate in the euro area using multiple linear regression analysis.


MULTIPLE LINEAR REGRESSION


The equation used will be in the form

INFLATIONX = a + b1 EURUSDX + b2 OILX + e

Where:
INFLATIONX
is the year on year inflation figure for month x.
a is a constant
EURUSDX is the EURUSD exchange rate in month x
O ILX is the Brent crude oil 1-month Forward - fob (free on board) per barrel in Euro for month x
e is a random error term
b1 and b2 are regression coefficients



DATA

Monthly data will be used in the analysis starting from January 1999 to April 2014. All data is obtained from the Eurostat and ECB.

Inflation
The inflation indicator used is the Euro area (changing composition) - HICP Overall index, Annual rate of change, neither seasonally nor working day adjusted.

Fig 1

EURUSD

The EURUSD exchange rate used is the average of observations through monthly period. Fig 2 shows the graph for the observed data.
Fig 2

Oil
The Oil prices used are the Brent crude oil 1-month Forward - fob (free on board) per barrel, average of observations through period in Euro, provided by ECB as shown in Fig 3 below.


Fig 3


ASSUMPTIONS


The following assumptions were made in the research
  1. The relationship between inflation and the independent variables which are the EURUSD exchange rate and oil prices, is of a linear nature. There is no relationship between oil prices and the EURUSD exchange rate
  2. All the assumptions of multiple linear regression hold.
RESULTS AND ANALYSIS

Microsoft excel was used in the regression analysis. Fig 4 shows the results of the analysis.


Fig 4

The total number of observations on the research was 184. The R2 and Adjusted R2 are 0.100235312 and 0.09029312 respectively.
The low values of the statistic indicate that there is a great deal of scatter in the data.

The significance of the model is tested by Anova. Since the Significance F is very low i.e. 7.0578 E-05 then we can conclude that the model is statistically significant.

The p values of the coefficients show that all the coefficients are significant at the 99% confidence level since all the p values are less than 0.01.

EURUSD
The coefficient of the EURUSD is - 1.36875465. This means that there is an inverse relationship between the EURUSD exchange rate and inflation. The exchange rate affects inflation in a number of ways:
  • Changes in the prices of imports. An appreciation of the exchange rate usually reduces the Euro price of imported consumer goods and durables, raw materials and capital goods.
  • Commodity prices: Many commodities are priced in US dollars, so a change in the EURUSD exchange
    rate has a direct impact on the Euro prices of commodities such as food stuffs.
  • Change in the growth of Euro exports. A higher exchange rate makes it harder to sell overseas because of a rise in relative Euro prices. If exports slowdown then exporters may choose to cut their prices, reduce output and cut-back employment levels.
OIL
The regression coefficient for oil is 0.01517399 which is a positive relationship between the oil prices and inflation. The reason is that oil is a major input in the economy. It is used in critical activities such as fueling transportation and heating homes and as such if input costs rise, so should the cost of end products.

CONCLUSION

Oil prices and the exchange rate are not the only variables that influence inflation in the euro area. There is scope to include in the model other variables such as housing statistics, food prices, unemployment rate and industrial production output data as they all impact inflation directly or indirectly.

In its fight against inflation the ECB should also ensure that the EURUSD does not become a hindrance in achieving their inflation target of close to 2%. Though the exchange rate is not a policy target now, if inflation remains low or continues to slow down then the ECB may be tempted to review its policy. Switzerland already has a policy on the exchange rate, whereby the value of the EURCHF has a floor of 1.2000. With the interest rate already at 0.15% the market can expect further rate cuts and possibly quantitative easing in future as the ECB tries to combat low inflation in the region.
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