Ambrose Evans-Pritchard of the Telegraph voices his concern that central banks are going to misread the impact of rising oil prices and therefore make the wrong interest rate decision. Bear in mind that Evans-Pritchard called the 2008 oil spike correctly, deeming it to be a bubble, and was also in the minority then in arguing that deflation was a bigger risk to the economy than inflation.
One leg of his argument is that oil price increases slow economic growth. That’s hardly startling; indeed, this concern has been echoed widely in the last few days. For instance, as David Rosenberg notes, courtesy Pragmatic Capitalism:
It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock.
Evans-Pritchard highlights several issues: no one seems to have a good measure of the impact, but there is reason to think it is larger than most central bankers allow for. And it also appears to be subject to inflection point effects, where increases beyond certain thresholds have disproportionate effects:
The classic theory by Rotemberg and Woodford (1996) is that a 1pc rise in crude prices cuts 0.25pc off US output over six quarters or so. If they are anywhere near correct – and the “energy intensity” of the US economy has diminished over time – the sort of 40pc rise since last summer rise will indeed have a severe effect. Subsequent scholarship suggests this is too extreme, unless central banks behave like idiots.
Deutsche Bank says US crude at $120 a barrel would push oil costs to 5.5pc of global GDP, the trigger level that has historically caused upsets….
Eduardo Lopez, a veteran oil watcher at the International Energy Agency, said the world was already “approaching dangerous waters” before North Africa blew up. He places the inflexion point at around $90 for US crude.
The second leg of his argument is that central bankers run the risk of raising rates too early. He contends that they are about to repeat the mistake they made in 2008, of ignoring the contraction in broader measures of money:
Conjuring ghosts of the 1970s is a certain formula for error. In that era M3 money was exploding. A wage spiral was well under way. There is no such pressure now (except, arguably, in Germany). After a spurt last year, M3 is contracting again in Euroland and the US on a month-to-month basis.
China, India, and parts of the emerging world may well be in a 1970s bind, but 60pc of the global economy is not.
The conundrum here is whether you believe some of the commodities price rises to be the result of financial investors using commodities futures as an inflation hedge is leading to distortions in the real economy. Even though Serious Economists pooh pooh this notion, economists at the UN’s Food and Agriculture Organisation, who have mucked around with the data, take the idea seriously. And one can construct transmission mechanisms. Long financial investors buy index futures, increasing their prices. Because all right thinking people have been trained to believe that market prices have information content, the futures price is taken to mean that Informed People think Stuff is Gonna Get More Expensive Soon.
So what do rational actors do? They run around and buy up physical supplies and maybe hedge too. And if you are a big commercial user, you probably have your own storage facilities, which will not show up as official inventories. Even retail hoarding can have an impact on demand. During the oil crisis, when gas stations moved to even-odd day fillups (based on license plate numbers), consumers kept their gas tanks fuller than normal. So even though any price move in the spot market would entail hoarding (as Serious Economists have said), a lot of those inventories would not be captured in official statistics , leading economists to then declare that the price change was the result of fundamental forces.
In effect, the authorities seem to have convinced themselves they have decent measure when they don’t. They’d probably do better to look at qualitative indicators as well as any data they can get their hands on, but most economists have an acquired allergy to anything that cannot be forced through a regression analysis.
But the concern that low interest rates are goosing asset prices hardly seems farfetched. Whether Bernanke admits it to himself or not, his program certainly looks like an effort to raise housing and stock market prices and hope the economy follows. And it is therefore entirely logical to expect “substitutes” for these targets, like storable commodities, to also be affected by monetary easing. While the US is so keen to continue to prop up asset markets to help its buddies in banking that the notion that the Fed will be too quick to raise rates does not seem credible. However, with Turbo Timmie loudly proclaiming that the economy is on the mend, the officialdom here is at risk of starting to believe its own PR.
That in turn means central banks may have no way out. They may not be able steer a road between inflation and a resumption of Japanese-style low growth and borderline deflation. They can only choose one or the other.