Oil price to determine inflation - BoI

Rising oil prices are likely to buoy inflation and prompt the European Central Bank (ECB) to tighten interest rates, according to Bank of Ireland’s June Bulletin.

This morning oil prices rose to a new record high just below $142, sending European stock markets lower.

Food and fuel prices have risen sharply over the last 12 months; 6.4 per cent and 13.7 per cent respectively, and together they have pushed the euro zone annual inflation rate to the current 3.7 per cent.

Dan McLaughlin, chief economist with Bank of Ireland, said the inflation acceleration was likely to result in the ECB raising rates by 0.25 per cent next month, "contrary to our and most of the market's expectation that the next move would be down".

He said markets have now priced in the expectation of a half point raise in rates by the end of the year.

"Higher rates will not affect inflation in the short-term, but the rationale is that it will help to anchor inflation expectations and convince firms and households that the ECB will do all it can to bring inflation back to the target", Mr McLaughlin said.

He noted that consumer's expectations of inflation probably owed more to high frequency purchases such as food and energy than Central Bank policy.

"In that sense the near-term path of oil prices will prove decisive in determining headline inflation, expectations and hence ECB policy," he said.

"A further acceleration in oil prices and further spike in headline inflation may mean even tighter policy, however, even though the resultant slowdown would be such that the ECB would probably end up cutting rates aggressively in 2009."

Mr McLaughlin said with rates now unlikely to fall the euro may end the year around $1.50 instead of the $1.40 forecast.