Quantitative Easing, Oil Prices And Recessions

Yesterday's post The Fed's QE2 — Speeding Our Demise described the longer term effects of a new round of money printing by the Federal Reserve. A weaker dollar will be a direct outcome, but a weaker doallar has consequences which policymakers have either not taken into account or simply don't care about. One consequence will be to drive speculative money into commodities trading.

In The Real Meaning Of The Oil Price, I described how oil prices have been driven by two factors unrelated to supply & demand—

• The oil price is positively correlated with the S & P 500
• The oil price is negatively correlated with the dollar

Even without a formal announcement of QE2, the markets have got the ball rolling in anticipation of another round of money printing—

Since Bernanke started laying out the rationale for further easing in his speech at the Fed's annual bash in Jackson Hole, Wyo., in late August, the U.S. Dollar Index has declined roughly 7% against that basket. Over the past six weeks, gold is up more than $100 an ounce, topping $1360 as the Fed and other central banks engage in their race to debasement. During that same span, the Wilshire 5000 has gained about $1.3 trillion in value, or about 9.9%...

Just as we would expect, oil prices (mouse over 1q, right) have gone up since late August as the dollar index declined (left).

Unlike three years ago when the oil price was surging toward $100/barrel, news sources are now quite explicit about the connection between the price and financial speculation. For example, look at this story from the Wall Street Journal—

LONDON—Crude futures were under pressure Tuesday, extending Monday's sell-off as appetite was subdued by the dollar's rise against the euro...

But it is the failure of the front-month U.S. crude benchmark to hold above $83 a barrel recently that has left speculators nervous, said Olivier Jakob, managing director at Petromatrix.

"The buying-oil-and-selling-the-dollar trade has become crowded," Mr. Jakob said.

Large speculators have gone long on crude futures, in expectation of a further round of U.S. quantitative easing, but they will need new buyers to come into the market in order to offload their positions at a profit, Mr. Jakob noted.

I'm not going to go into the details, but trust me on this: based on the fundamentals of supply & demand alone, there is no reason for the oil price to be above $80/barrel.

In a world in which the oil price doesn't matter much, like the world of the 1950s or 1960s, who would care what today's price trend is? Unfortunately, we don't live in that world anymore. The era of low oil prices is gone forever, and prices would still be relatively high today even if speculators were not driving the price beyond its fundamental level.

High oil prices are a significant drag on the economy. If the oil price gets high enough, past experience demonstrates that recessions follow. The only controversial part is identifying just how high the price must be to trigger a recession.

I should note before proceeding that the record-setting oil price of 2008 was not the main cause of the "Great" recession. In fact, the recession began in the 4^th quarter of 2007, before the price surge in mid-2008. Even here, sorting out cause and effect gets tricky because the oil price had been rising throughout 2007. On the other hand, house prices started declining in mid-2006.

Undoubtedly, the surge in oil prices accelerated the deterioration of economic conditions in 2008. However, the financial meltdown in the fall of 2008 and the tailspin that followed was certainly not caused by high oil prices. To understand that, we must look at the collapse of the Housing Bubble and various structural imbalances that existed in the economy for many years (or decades) before that.

Back in July of this year, economist James Hamilton took a look at whether an oil price in the $80s was affecting the economy. His analysis was based on a theory put forth by oil analyst Steven Kopits.

Oil expenditures as a percentage of U.S. GDP. Recessions are indicated by shaded areas and dashed line is drawn at 4%. Oil expenditures calculated as average monthly price of West Texas Intermediate (from FRED) times 365 times average daily petroleum product supplied to U.S. markets over the last 12 months (from EIA). Nominal GDP from quarterly BEA Table 1.1.5 interpolated to form a monthly series. Recession dates from NBER.

The above graph is an adaptation of Steve Kopits' portrayal of the rough monthly value of U.S. crude oil purchases as a percentage of GDP. We came near what Steve suggests is a critical 4% threshold in the spring, but oil price declines since then have brought the share back down a bit.

I have not seen an update of this graph since July, but the point is clear: according to Kopits' interpretation of the historical data, we risk a recession if oil expenditures get near or rise above 4% of nominal GDP, and stay there for some period of time. A weakening dollar driven by another round of quantitative easing will cause the oil price to rise as I explained above. You don't need to be a rocket scientist to see that in a very weak economy, a rising oil price could, after some critical threshold is passed, put us right back in recession. (I am ignoring the controversial assumption that we are not in recession now.)

Higher oil prices are thus the main short-term threat posed by another round of quantitative easing. I don't know if this is an unintended consequence of the policy—I presume it is. We are once again forced to conclude (as we did in yesterday's post) that QE2 will speed the Empire's decline.

 

Comments

[Edward Boyle]

1 Trillion stimulus to big banks has to go somewhere there's a profit. Junk bonds, US govt. bonds, maybe stocks and of course commodities like oil. Just wait till wheat, rice, corn, soybeans go through the roof. Helicopter Ben wants inflation. He'll get it for sure. Of course cars and houses will be dirt cheap. Only people will be starving and freezing. Great fun.