Ahead! An Oil Slick on the Fed's Road

Oil is an especially viscous fluid that can slip and slow you up. Ben Bernanke, the chairman of the Federal Reserve, is living through that lesson now in his management of the U.S economy. But both the net rise and the volatility of oil prices over the past nine months were not likely to have been a surprise to him. Rather, they are a predictable byproduct of the Fed's expansion of its balance in its policy known as quantitative easing (QE). The Fed gambled that the benefits of the stimulus of QE to financial markets would offset the adverse effects of oil price developments. Whether that gamble pays off is yet to be proven.

QE was essentially designed to give a nudge to risk taking. Late last year, Fed officials announced they would purchase $600 billion of riskless Treasury securities over the period from November 2010 to June 2011. The hope was that investors would reinvest the proceeds in riskier assets. The resulting lift to equity prices and decline in corporate rates would, the theory runs, support economic expansion. The nudge to risk taking from QE seemed like mission accomplished for a time. Stock prices moved significantly higher and yield spreads narrowed once QE was seen as inevitable.

But not all the effects of QE have played out in financial markets. Since the Fed firmly signaled in August its intent to launch the latest round of QE, oil prices have risen from $76 to around $100 per barrel.

Why does the Fed's balance sheet matter for oil prices? The producers of oil as well as other commodities typically sell their output in a worldwide market priced in U.S. dollars. Thus, they care about the current and expected future purchasing power of the dollar and how that will translate into goods and services back home. But QE has been associated with higher inflation and dollar depreciation, which combines to erode the purchasing power of the foreign producers of commodities. Thus, some of the rise in the nominal price of oil has been to catch up with that erosion.

Much more important in shaping near-term oil-price dynamics has been the nudge to investors from QE to move from safe to riskier investments. The commodity market has been one outlet for that reinvigorated search for yield. Investment flows into commodity-related vehicles has stepped up noticeably. This has been reinforced by the Fed's policy of keeping short-term nominal interest rates near zero, which keeps it cheap to do some of that trading on borrowed funds. Such speculation neither produces nor consumes the commodity, so it should have no long lasting effect on prices. However, over short periods, it can fuel spasms of enthusiasm or angst that trigger wide swings in prices. Oil markets experienced just that about two-weeks ago when futures prices posted their biggest one-day drop.

This increases in the price of oil and its heightened volatility poses three distinct problems for the Fed.

First, a rise in energy costs of one-third takes a distinct bite out of American households' budgets, working to restrain spending in an economy already burdened by lingering balance-sheet problems from the 2008-2009 financial crisis. This probably explains why the expansion of real GDP thus far this year has fallen short of most analysts' expectations. As of yet, however, the oil-price shock is not as large as those associated with severe economic dislocations of the past half century. For example, the recent rise in oil prices is small relative to the 150 percent hike from 2007 to 2008 that added to the headwinds creating recession.

Second, increases in the price of oil, as well as those of other commodities, has fueled an upsurge in inflation. Over the past six months, consumer price inflation has been running at a 5-3/4 percent annual pace and the dollar has depreciated on the foreign exchange market. But Fed officials had been worried for at least the past year that inflation might get too low relative to its mandate of price stability. Therefore, some lift from the prices of energy and other tradeables was probably not unwelcome to them. Further, they continue to believe that people are not likely to expect the prices of other goods or services to rise commensurately. If so, and if commodity prices do not continue to rise, then the level upshift in oil prices will pass out of inflation calculations in due course.

Third, in recent months, the world seems to be a much less safe place than usual, with unrest in the Middle East, uncertainties about Japanese energy supplies, and changeable speculative flows in commodity markets. These combine to make the near-term balance between oil demand and supply volatile. They could, to the Fed's regret, also make global investors more skittish and undercut some of the benefit in financial markets attributable to QE.

On net, it is likely that the economy-wide effects of the energy shock are unpleasant but not derailing to expansion. But this is a gamble, and one Fed officials must apparently have accepted when they decided to launch QE. We will live with the consequences of that judgment in coming quarters.

Vincent R. Reinhart is a resident scholar at AEI.

Also Visit
AEIdeas Blog The American Magazine
About the Author


Vincent R.

What's new on AEI

Holder will regret his refusal to obey the Constitution
image 'Flood Wall Street' climate protesters take aim at their corporate allies
image 3 opportunities for better US-India defense ties
image Is Nicolás Maduro Latin America's new man at the United Nations?
AEI on Facebook
Events Calendar
  • 29
  • 30
  • 01
  • 02
  • 03
Thursday, October 02, 2014 | 9:00 a.m. – 10:30 a.m.
Campbell Brown talks teacher tenure

We welcome you to join us as Brown shares her perspective on the role of the courts in seeking educational justice and advocating for continued reform.

Event Registration is Closed
Friday, October 03, 2014 | 12:00 p.m. – 1:00 p.m.
Harnessing the power of markets to tackle global poverty: A conversation with Jacqueline Novogratz

AEI welcomes you to this Philanthropic Freedom Project event, in which Novogratz will describe her work investing in early-stage enterprises, what she has learned at the helm of Acumen, and the role entrepreneurship can play in the fight against global poverty.

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.