On the Problem Rising Oil Prices Pose for Central Banks

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.

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  1. psychohistorian

    Thanks Yves. Lots of food for thought.

    A question that keeps coming to my mind is the unknown price of various things that does or doesn’t keep the derivative market from blowing up and taking everything down. Any thoughts?

    As I said before about commodities nowdays, even joe6pak is starting to wake up to the long term inflationary pressures on the US dollar and securities are too manipulated so its metals or commodities.

    My thought after reading your last paragraph is that this is when the political side of the economy starts a war to obfuscate things……..

  2. Ivo Cerckel

    “Money will always flow toward opportunity”, said Warren Buffett yesterday.

    Could the problem with the oil price be the currency in which its price is being expressed?

    As Bronwen Maddox said earlier this month in The Times:
    The US should also assume that if Saudi Arabia does eventually erupt, shaking off its royal family, the results will be far more explosive than in Egypt, and a new regime, very likely Islamist and radical, might prefer to sell its oil to China. http://www.thetimes.co.uk/tto/opinion/columnists/bronwenmaddox/article2912399.ece

    What if Saudi Arabia decided to price its oil in Honest Money?

    gold-renminbi, anyone?

  3. Ivo Cerckel

    Continuing to bail them out is continuing the greatest theft from the public purse in history.(ECONned, p. 6)

    In economics, hyper-inflation is inflation that is very high or “out of control”
    destroying the institution of money and also destroying the whole finely organised mechanism of production based on division of labour,
    it can cause a relapse into an economy without trade if the use of metal money or at least barter trade is not maintained/perpetuated (“aufrechthalten”, “aufrecht” = upright).
    But it cannot create anything.
    (Ludwig von Mises, “Socialism – An Economic and Sociological Analysis”, Indianapolis, Liberty Classics, 1981 (translation of the 1932 2nd ed. of “Die Gemeinwirtschaft”), p. 448).

    If Freegold,
    a freely floating price of gold which price is thus not marked, like the US Treasury does, to the model of USD 42 something (originally $35) ,
    but which price is marked to market (-price).(mark to market – MTM),
    will then be available, we will have the means to re-construct something.

    “Human potential is far from exhausted”, said Warren also.

    The only choice we the sheeple, not the central banksters have,
    is to be destroyed or to re-build.

    Screw all banksters, central or not so!

  4. Cathryn Mataga

    Just look at those other links. “How to profit” “four ways to profit” — part of it’s just the mid-east news, but oh, it just feels so frothy.  I figure when we see the late night info-mercials, and the Cable TV ‘make money in commodities’ educational programs, that’s the peak. Maybe there will be some nice bonuses as the bubble inflates.

    Of course, there might be a few negative consequences.

  5. yoganmahew

    Stagflation/stagdeflation… another Roubini prediction (and not just from him). Some of it related to peak oil, perhaps, but the necessity to pay higher wages to continue production (as in the ‘seventies) is gone. There is always somewhere cheaper to trade and high costs provide the marginal difference needed to justify the move (if not to actually increase profits!).

    So labour has no traction to demand wage increases. Living standards fall and the knock-on effects from that continue (to debt service, consumption etc.). From labour’s point of view there is stagflation.

    Longer term, though, the decline in economic activity and the destruction of money (through defaulted debt) will be profoundly deflationary. High commodity costs and low consumption, though, will mean that the stagnation continues.

  6. mannfm11

    It was my recollection that the odd/even days and the requirement you buy at least 8 gallons relieved the shortages. Prior, every time I was in line and there were lines in 1979, women in station wagons with nothing better to do were putting 4 gallons in their tanks to top them off at their 25 gallon limits. Once the lines were broken, people weren’t so damn afraid of running out of gas. The EIA storage numbers show a relative glut in oil products against 2008, 2007 and even the late 1990’s. This is instead an effort of Wall Street to push the prices up on their Texas hedge, long EOM, COP and CVT then long robotized oil futures. Pump and dump. Instead of hedging their oil stocks, they are driving them up. Even if they get stuck with the oil, they made their money off the stock. XOM has goine up $100 billion in the past few months. So has CVT

  7. Mark P.

    xYves wrote: ‘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.’

    [1] Ouch. I know what you mean (I think). But that sentence could have stood some copy-editing.

    [2] That said, sure. Bernanke is obviously trying to pump up U.S. real estate and stock prices, praying the American economy follows, and instead — as Ivo Cerckel suggests with that Buffett quote — the U.S. financial industry is, of course, pushing much of that free QE money overseas into commodities investment and speculation.

    [3] You write: “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.”

    Possibly not our greatest worry re. commodities. We are also witnessing a problematic synergy of global oil and food prices, and aquifer depletion. As follows —

    [4] Some 18 countries — including the U.S., China and India, the big three grain producers — have inflated food production in recent decades by seriously overpumping aquifers to irrigate their crops. ‘Food bubbles’ based on this overpumping of underground water now appear to be bursting, shrinking grain harvests in many countries. Drought and increasing climate volatility will make expansions of food production more eiffy.

    See forex:

    [5] The ME is particularly problematic, of course. Egypt — where crude oil production peaked in 1995-96 and has dropped ever since, even as oil consumption increased at a rate of 3 percent annually — is becoming a net oil importer, for instance. Higher oil prices since 2004 have already increased 3-fold the cost of the food and gas subsidies (from 3 percent to 9 percent of Egypt’s GDP)on which the Egyptian population depends. Other countries in the region face various but related difficulties. These, in turn, are a critical trigger for the political volatility we are witnessing.

    [6] This political unrest won’t go away. Into this potential cauldron, furthermore, factor in Bernanke’s power to decree fiat dollars in existence that he feeds to the U.S. financial industry, which then buys up/speculates in the commodities on which populations elsewhere depend, driving up those commodiites’ prices further.

    I take what the economist Michael Hudson says critically. But I also think he’s the real deal. And here’s some of what Hudson says on this subject.

    ‘…The Fed’s quantitative easing policy– creating more liquidity so that banks can lend more – aims at helping the economy “borrow its way out of debt.” But banks are not lending more, for the simple reason that a third of U.S. real estate already is in negative equity….’ etcetera

    ‘…China and Germany … want to avoid having instability disrupt their trade and domestic production, and … having to take a loss on their international reserves held (mainly from inertia stemming from World Wars I and II when the United States increased its share of the world’s gold to 80 per cent by 1950). The U.S. Treasury would like U.S. banks and speculators to make an easy $500 billion at the expense of China’s central bank on slick speculative currency trading. The Fed would like to see the U.S. economy revive by looting other economies.

    ‘It’s not going to happen. ..

    ‘…Chinese authorities have tried to make it clear … that they object to … the U.S. policy of creating “electronic keyboard credit” at one quarter of a percent (0.25 per cent) to buy up higher yielding assets abroad (and nearly every foreign asset is higher yielding). The Group of 20 in Seoul Korea last week accused the United States of competitive currency depreciation and financial aggression…The plunging-dollar standard of international finance is being wound down as fast as other countries are able to replace the dollar with currency swaps among themselves, led by the BRIC countries (Brazil, Russia, India and China).’

  8. Brick

    The problem is not just that futures don’t necesaarily reflect futures, but that it has become a lot easier to trade in them through ETF’s. This means that there are a lot more market particpants than there use to be, most with a much shorter term view than traditional market players. In sum it is easier to speculate and thats why margin requirements have been hiked. Incidentally those margin hikes cost physical players in the market problems and puts a floor under final products, such that gasoline prices start to reflect margin requirements. The long term problem is volatility and the floor thats put under the market by liquidity.In otherwords the collapse when it comes will not be as big as the rise and the fundamental long term inflation trend in commodities will have gone up. Central banks have a problem with identifying not just whether it is a bubble but whether the long term trend has changed and whether that is due to their actions.
    As for central banks rising interest rates too quickly, then I think the nature of different credit markets will determine the effect. Credit markets outside the US are strutured slightly differently due to less interference. This means that credit will normally have things like collars outside of the US, meaning that the cost of credit does not change as much outside the US when central banks rates are below that collar level. Typically the effects of low central banks rates diminish once you get below 2%. This gives banks outside the US more leeway to act and change the value of there currency without a big impact on the economy.This does of course hurt the banks, who are being bailed out by low interest rates. In summary the effects are different, with slightly different choices for central banks. The Fed would appear to be the central banks with the least room to manouver by nature of the fact that politicians have their big oar in the mortgage and credit markets.

  9. jake chase

    What we are seeing is the mushrooming of the Fed’s asset bubble. Sooner or later the commodity speculators will run for the exits, probably all on the same day.

    The deflationary force is housing. The Fed has priced out an entire generation of home buyers, most of those stuck in existing houses have no equity, no ability to sell, no job security, nothing keeping them out of foreclosure except securitization screwups.

    Other than bailing out banks the government entertains no solutions except austerity. How does that translate into inflation?

  10. rd

    The MSM has simply turned into a pack of mad dogs baying at the moon on the question of oil prices. They are breathlessly reporting on moves in WTI futures while ignoring the vast majority of the world’s oil pricing. So you get major pronouncements of “oil plunges in today’s trading” when prices like Brent crude actually rose.

    For specific structural reasons, WTI has simply turned into a traders’ playtoy that bounces up and down with little apparent linkage to the real oil markets. Historically, Brent crude and WTI tracked fairly closely. WTI is now more than 10% lower than Brent crude which is a huge tracking error.

  11. Bribes

    I do enjoy how The Shrill One, though not named, is probably among the “Serious Economists” getting poked (deservedly or not) in this post. It’s a fantastic change of pace.

  12. Doug Terpstra

    Yves, thank you for cutting through the “rational pricing” BS of “all right-thinking people”— just as you do in ECONNED, with self-evident common sense on the root causes of speculative gambling. Future historians will undoubtedly place you at the all-important tipping point in the demise of neoliberal economics and award you with an honorary doctorate in behavioral economics.

    Alas, despite the “pained” confessions of Greenspan, Ben Bernanke is just like that same willfully-blind boy with a hammer, to whom all people look like nails. The consequences of his fatally-flawed, neoliberal model are even now sweeping through the imperial colonies, and blowback will inevitably flare in the homeland as well. This will lead to the “spontaneous” combustion of the Criminal Reserve (ZeroHedge) and the Wall Street casino, while the oblivious plutocracy cries patriotic martyrdom.

  13. dave

    There seems to be this belief that new money somehow increases prices fairly equally. That easy money will cause wages, like all prices, to rise. That seems crazy. When you create new money it doesn’t apply itself equally to all prices. It applies itself to those prices where there is a supply bottleneck. Labor is plentiful, while commodities are finite. If you support easy money you basically support rising commodity prices in the face of stagnant wages. That seems a lot worse for workers then rising commodities and rising wages, IMO.

  14. Robert Dudek

    The solution is not to print money and give it to the banksters. The solution is to print money and give it to the labor force and small and medium-sized businesses. In that way, and only that way, the private sector will see sufficient increase in demand for its products and services to get out of the stagnation we are in now.

  15. financial matters

    Ending QE and raising interest rates would at least be moves toward reality. Stop propping up home prices that need to move in line with incomes. Stop exporting inflation in commodities. Stop debasing the major world reserve currency. Stop convincing the stock market that there is endless money to keep propping it up.

  16. Hugh

    I was writing about what was happening in oil and predicting recession as a result (from both it and the housing bubble burst) in 2007. It’s important to remember what we are seeing is inflation within deflation, that is inflation in commodities pricing within the larger pattern of falling housing prices and high unemployment (both of which subtract from aggregate demand). The inflation in commodities pricing is just another stressor because food and oil being fairly inelastic in demand, siphon wealth away from the rest of the economy, unproductively.

    I’m more with Lopez and have written also about $90 oil and recession. It’s natural for oil markets to react to political blowups like those we have seen. But if this is natural speculation, then we would expect traders to look around, see that the oil is still flowing, and back off in their pricing. This should happen in the next week or two. If it doesn’t, if there is not a fall back to the pre-crisis baseline, then we will know that this is excess speculation, that is that the speculation is, in fact, not being driven by fears and concerns about external events but rather that these are being used as an excuse to cover for pure financial manipulation of the market.


      $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

      ~~Yves Smith~

      There is always a drop or two of momentum speculation, but in the face of US production build for the past couple of months, announcements from King A. of plans for his build in production, one then looks at demand. Demand? What demand? With January new home sales at 1/5 the level of January 2005 you can just bet that folks are not moving to the suburbs to burn up lot of commuter’s energy in the near future. With one child per parent precedent now set firmly in ChineseVille, future shrinkage of Asian demand will not bode well for futures contracts in petroleum products or/& crude. Way further down the road, by contrast, peak oil is an insurmountable problem.

      1. USA Production peak 1970

      2. Iran peak 1974

      3. Arabia 1980

      4. U S S R 1987

      Will peak oil dampen plans toward economic expansion before it escalates spot and contract barrel prices? Unfolding of that étude will be a slow process not precipitated by restless natives milling around at the wells, not sudden, but much more profound. Has peak oil dampened already our shovel ready plans for bridges and highways to prevent Japanese Type Disinflation? How long does highway last? 99 years? Lot longer than fuel for service station pumps?

      No need to build highway

  17. Max424

    “Eduardo Lopez…places the inflexion point at around $90 for US crude.”

    There are no grand inflection points.*

    Oil at $70 is bad. Oil at $90 is worse. Oil at $ 110 spells trouble, oil $130 spells bigger trouble.

    Inflection points. Who comes up with this sh+t? Reminds me of all the stories I get from black jack players; “I was running hot, then out of nowhere, some ‘I double down on 3s’ clown joins the table and changes the card flow, changes my table’s karma!”

    There is no karma, jack. There is only dealt cards, odds and percentages, and inexorable math.

    Step back from Hubbert’s Peak, and you will see no inflection points. Step far enough back, and you can’t even pick out a rough edge. At the right distance, you can only see a bell curve. A smooth, smooth bell curve.

    * A series of inflection points — that when all is said and done — blend into one? Yes, maybe there is that. First up (the canary in the coal mine): jet fuel and the airline industry.

  18. theyenguy

    Andrew Ackerman in Dow Jones Newswires article Geithner To Discuss Libya, Iran Sanctions Tuesday in Germany reports U.S. Treasury Secretary Timothy Geithner plans to visit Frankfurt and Berlin Tuesday for meetings with senior government officials there, the Treasury Department announced Friday. Geithner will discuss “global efforts to impose sanctions applying maximum pressure” on the regime of Col. Moammar Gadhafi of Libya as well as sanctions on Iran for its “failure to meet its international obligations,” Treasury said. Treasury said Geithner’s agenda also includes a discussion of the global economic outlook and progress on international financial overhaul.

    Timothy Geither will most assuredly meet with Angela Merkel, as the world faces a two fold critical juncture.

    The first critical juncture is the presentation of the German and French developed Competitiveness Pact which Leigh Phillips in EUObserver February 9, 2011 article Eurozone Summit Looms Amid Growing Hostility to Franco German Pact reports would mandate a common corporate tax base, harmonise retirement ages, eliminate indexation of wages to inflation, and establish a debt brake on government debt via constitutional amendments. This pact does noting to address the current sovereign debt crisis of basically insolvent European Financial Institutions, EUFN, such as Banco Santender, STD. Nor does it address the burdensome interest rate on the recently announced Bailout Agreement for Ireland. Nor does it address the ongoing funding needs of Portugal, which has no debt seigniorage, but instead finances its needs by selling debt to the ECB.

    The second critical juncture is that the economic and political paradigm of Neoliberalism failed on, February 22, 2011, as seigniorage failed, with the downturn in distressed securities, like those held in FAGIX, which caused the stock market, ACWI, to turn lower from its February 18, 2010 from a high of 49.24.

    Bible prophecy of Revelation Chapter 13 communicates that a new political and economic paradigm, that being rule of the sovereigns, will emerge out of Götterdämmerung, an investment flameout, where a Chancellor, that is a Sovereign, and a Banker, a Seignior, will arise and govern through global corporatism. Such leadership may come out of Germany heralding the strength of a revived Roman Empire, as Germany has its ancestral roots in that former empire. National leaders will waive national sovereignty and announce Framework Agreements. These Agreements will appoint stakeholders to oversee regional economic governance. The two leading Sovereigns will provide a new seigniorage, that is a new moneyness, with austerity and democratic deficit for all. Perhaps one of these two leaders will be EU Council President Herman Van Rompuy as he has defends the European Union as being the “fatherland of peace” euobserver.com, January 17, 2011. The word, will and the way of the sovereigns will be law replacing constitutional as well as historical rule of law.

    I encourage a read of my article … Will Angela Merkel’s Competitiveness Pact Resolve The Eurozone’s Issues? …. to help understand that the world stands now at a great inflection

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