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Page added on January 30, 2016

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The Fed’s Oil Price

Public Policy

In 1997, Ben Bernanke wrote a paper that argued the effect of an oil price shock can be compared to a change in monetary policy.

If Bernanke’s 1997 model were applied today, a lower oil price could reduce GDP by 0.5% in the next three to four quarters as a result of tightening financial conditions.

The dilemma the Fed faces of having to stay neutral in the wake of lower oil prices keeps uncertainty high. Markets will therefore discount uncertainty with higher volatility and wider spreads.

In 1997, Ben Bernanke wrote a paper about the relationship between the price of oil and monetary policy. The paper’s thesis is the effect of an oil price shock can be compared to a change in monetary policy. If the oil price rises quickly, the economy would slow down by the equivalent of hiking several times the federal funds rate. In the 1990s, the comparison between a higher oil price and tighter monetary policy made sense because the economy was “price elastic” to oil demand. Higher oil prices would translate into higher gas prices which curbed consumer spending. Regardless the level of crude output, any change in the price of oil had a direct effect on aggregate demand. Transmission through markets worked similarly: rising oil prices would drive interest rates higher and lowered equity valuations on the prospect of a weakening economy. In Bernanke’s view, a rise in the oil price was therefore the equivalent of tightening financial conditions by hiking the fed funds rate. As such, monetary policy should not react to higher oil prices but rather stay neutral, or in a worst case scenario, ease to offset the negative impact on the economy.

Today’s economy is “price elastic” to oil supply. A fall in the oil price and resulting lower gas prices have so far not led to materially higher consumer spending. The Bureau of Economic Analysis statistics showed for every dollar of gas savings in 2015, consumers have almost saved an equivalent amount. Whereas in the 1990s, higher oil price would lower consumer demand, today a lower oil price increases the supply of excess savings. Thus, regardless of the level of oil demand, a lower oil price leads to excess supply. In response, financial markets transmission has been the opposite from the 1990s: a lower oil price drives interest rates lower and equity prices down. This is a result of tightening financial conditions caused by a stronger dollar, coupled with oil output that remains at a record high. This has caused distress in the high yield energy sector and commodity exporting emerging markets, which has spilled over into global equity markets.

If Bernanke’s 1997 model were applied today, a lower oil price could reduce GDP by 0.5% in the next three to four quarters as a result of tightening financial conditions and lower equity valuations. The output decline is worth approximately 2 to 3 rate hikes. Markets have therefore discounted across each meeting at less than a 35 percent probability of one hike. The FOMC would have to take note of tightening financial conditions as those are now combined with inflation expectations that have shifted lower. As a basic rule of thumb, for every 10% decline in the oil price as a result of tighter financial conditions (mainly through the dollar), inflation expectations by 0.25 percent since July 2014.

The concept of a “breakeven oil price” may apply to the Fed and other central banks with regard to stabilizing inflation expectations. If the oil price settles permanently lower, inflation expectations may become “structurally” lower. It would become under such circumstances very difficult to reach the inflation target. This is perhaps why inflation linked forward market discount inflation will not see 2% in the next 15 to 20-years. Thus, the breakeven oil price where financial conditions normalize and long-term inflation expectations move back towards 2 percent may be closer to $45-$48/barrel based on the basic rule of thumb relationship between oil and inflation expectations. Currently, forward oil markets see this happening in 5 years from today.

The FOMC has to convey once more a message of gradual tightening. However, given the sharp fall in oil price, the Fed should in Bernanke’s playbook actually shift to neutral or may even consider easing. FOMC members like Dudley and Bullard have acknowledged inflation expectations are slipping and that decline is a concern. Considering the Fed wants to maintain a bias to hike, low oil prices will once again emphasize the view of markets that fed funds may not be able to reach 2 percent in the next 3 to 5 years. The dilemma the Fed faces of having to stay neutral in the wake of lower oil prices keeps uncertainty high. That is because it remains doubtful the Fed and other central banks can fulfill their mandates. Markets will therefore discount that uncertainty with higher volatility and wider risk premiums until the “Fed’s price of oil” finally normalizes.

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27 Comments on "The Fed’s Oil Price"

  1. makati1 on Sat, 30th Jan 2016 11:17 pm 

    Who cares? This is an ongoing up and down discussion going nowhere. I personally hope it all tanks before there is nothing left for my kids and theirs to survive the future. Crash and get it over with.

  2. GregT on Sun, 31st Jan 2016 3:01 am 

    I have come to the conclusion that human beings are neither rational, nor intelligent. Modern industrial society is the result of a cheap abundant supply of energy, as are the markets, finances, GDP, human population growth, and the price of bananas in El Salvador. The modern school of economics is without a doubt the most irrational human construct ever devised, and will ultimately result in extremely bad consequences for every single last one of us.

    Dumb fucking human apes.

  3. onlooker on Sun, 31st Jan 2016 3:57 am 

    Yes we have behaved no differently than yeast in a petri dish, mindlessly consuming and reproducing with no thought or care about the future.

  4. Boatm on Sun, 31st Jan 2016 7:12 am 

    GregT

    Yet you participate like most capitalists. How rational is that. Doomers are a funny breed thinking they are any different. They even increase their carbon foot in prepping to survive all the while eating up earths resources like anybody else. Truly a disillusioned lot.

  5. markisha on Sun, 31st Jan 2016 7:24 am 

    Greg you are completely right and the most evil human construct is Law . I am a lawyer I know believe me

  6. Davy on Sun, 31st Jan 2016 7:37 am 

    The Chinese currency debacle along with its non-preforming loans “NPL”, foreign reserve burn rate, and popping banking sector bubble all point to a near term volatility through the rest of the year. This is not going to end well for the huge global foreign exchange markets. China is trapped in an incongruous juxtaposition of tightening and easing. They have no good options and seem to be paralyzed. This paralysis means fate and chance are going to trump leadership. They are stuck reacting and most often reacting poorly just making the problem bigger.

    This problem is the problem everyone should be watching. China is too large to ignore. This problem too great. Currencies are going to be buffeted affecting all global currencies. Oil is going to be right in the middle of this economic storm. This Chinese contagion is a global demand killer which will likely ensure oil will not recover this year. In my opinion the global economy will not recover. This is going to smack the global equity markets very hard especially the US markets that are so overpriced.

    “A Chinese Banker Explains Why There Is No Way Out”
    http://www.zerohedge.com/news/2016-01-30/chinese-banker-explains-why-there-no-way-out

    “The real issue is the size of their banking system. Do you remember the reason the European countries ended up falling like dominoes during the European crisis was their banking systems became many multiples of their GDP and therefore many, many multiples of their central government revenue. In China, in dollar terms their banking system is almost $35 trillion against a GDP of $10 and their banking system has grown 400% in 8 years with non-performing loans being nonexistent. So what we are going to see next is a credit cycle, and in a credit cycle you see some losses, but if China’s banking system loses 10%, you are going to see them lose $3.5 trillion.”

    “Friday’s adoption of NIRP by Japan, which send the US Dollar soaring, has only made any upcoming future Chinese devaluation even more likely.”

    “whether China devalued or not, one thing is certain: it is next to impossible for China – under the current socio economic and financial regime – to stop the relentless growth in NPLs, which even by conservative estimates at in the trillion(s), accounting for at least 10% of China’s GDP.”

    “the main reason why China is now trapped, and on one hand is desperate to stabilize its economy and stop growing its levereage at nosebleed levels, while on the other hand it is under pressure to issue more loans while at the same time it is unwilling to write off bad loans”

    “why despite all its recurring posturing, all its promises for reform, all its bluster for deleveraging, China’s ruling elite will never be able to achieve an internal devaluation, and why despite its recurring threats to crush, gut and destroy all the evil Yuan shorts, ultimately it will have no choice but to pursue an external devaluation of its economy by way of devaluing its currency presumably some time before its foreign reserves run out (which at a $185 billion a month burn rate may not last for even one year).”

  7. Davy on Sun, 31st Jan 2016 8:23 am 

    “Doomers are a funny breed thinking they are any different. They even increase their carbon foot in prepping to survive all the while eating up earths resources like anybody else. Truly a disillusioned lot.”. Another distorted inaccurate statement of a diverse group.

    Many doomer/preppers practice a type of relative sacrifice. They live with less as part of their preparation for less. It is very difficult to prep and live in the status quo so sacrifice is required. Many of the best prep activities revolve around local activities which as we know have a lower footprint.

    I am a preppers that is investing my money in goods with a future. These items will be a store of value when the status quo is no longer functioning as it is today. Many of these products are available now and priced right. Many won’t be available latter with an economy in a depression. Many of these items will last for generations. It is a store of value and in that sense the carbon foot print must be amortized over many years of use. Many of the products I purchase are permaculture related so they are purchases that lower my future carbon footprint.

    To give a blanket condemnation on doomer and preppers like the above fails the “reality test”. If you are not prepping then you are like so many that live day today as a sheeple. Many just can’t and there is nothing that can be said about this group. They are stuck but they should not be condemning those who are not stuck and who can do something. It is always after the storm when people crawl out of the wreckage that the smart people are most visible. There is little we can do about fate and luck but there is a whole lot that can be done by increasing the odds.

  8. Boat on Sun, 31st Jan 2016 9:27 am 

    Davy,

    By living near a city my personal carbon footprint is very low. All my shopping to survive is just 3 miles away. I drive only to and from work. I have no need to travel for entertainment or vacation. I have an excellent energy heating system and a tight house. We have three wage earners and 7 people living in the house which makes it very cost effective per person. Plus it is fun to have a baby in the house. You like onlooker seem to think you could survive a system changing economic collapse. As mentioned, if a collapse includes nuclear melt downs, dam disasters, no energy infrastructure and food production. How are you so optimistic that the teeming hordes from emptying cities won’t overrun all land looking for a meal.

  9. ghung on Sun, 31st Jan 2016 9:50 am 

    Boatasks; “How are you so optimistic that the teeming hordes from emptying cities won’t overrun all land looking for a meal.”

    Knowing you’ll be overrun first, it seems like a silly question. At least Davy will see them coming.

  10. GregT on Sun, 31st Jan 2016 10:08 am 

    Boatm,

    The fact that you don’t have the slightest clue about what I was referring to above, only strengthens my point.

  11. onlooker on Sun, 31st Jan 2016 10:22 am 

    Yes Boat, Greg is bemoaning the fact that you do not grasp that he was referring to macro trends in which humans have taken an abundant energy source and build an entire worldwide civilization without making any provisions for the dwindling of that energy source and in the meantime harming the life support systems that all life depends on. But to be fair he just does not single you out but most humans as well.

  12. GregT on Sun, 31st Jan 2016 10:26 am 

    “How are you so optimistic that the teeming hordes from emptying cities won’t overrun all land looking for a meal.”

    Because if they are that desperate to find food, most won’t have the energy to make it very far.

  13. Davy on Sun, 31st Jan 2016 10:32 am 

    “By living near a city my personal carbon footprint is very low.” Sorry Boat, you may have a relatively low carbon footprint but within a high carbon environment. You have a high embedded carbon footprint being in a city. A city has a high carbon footprint by its nature. Food, water, and energy must be imported and concentrated then all that waste stream must be removed. I commend you for your low carbon footprint within a high carbon environment. I am not impressed with your understanding of carbon footprints nor your righteousness in ignorance.

  14. shortonoil on Sun, 31st Jan 2016 10:32 am 

    “Today’s economy is “price elastic” to oil supply.”

    In economics elasticity, and inelasticity refer to the relationship between P (price) and Q (quantity).* Perfectly elastic refers to a P/Q line that is horizontal. Perfectly inelastic is a P/Q line that is vertical. “price elastic” refers to a situation where the price stays constant regardless of the supply. Since June of 2014 the price has fallen by 70% with at most a 3% increase in supply. That is the price is inelastic, a huge change in price has only marginally affected supply.

    The authors at Seeking Alpha have gotten one of the most basic concepts in economics backwards. “Today’s economy is “price inelastic” to oil supply.” A change in price has not affected supply. We therefore conclude that Seeking Alpha is not qualified to comment on the subject of the monetary/ economic impact of a change in oil prices. This must also cast doubt on Mr. Bernanke overall understanding of the petroleum/ economic relationship.

    *Samuelson, “Economics”, 15th edition, page 60

    http://www.thehillsgroup.org/

  15. Davy on Sun, 31st Jan 2016 10:38 am 

    Cornucopians are reality elastic becuase their narrative remain the same regardless of reality.

  16. onlooker on Sun, 31st Jan 2016 10:56 am 

    But then they are as inelastic as possible when reality intrudes upon their comfortable perceptions.

  17. Northwest Resident on Sun, 31st Jan 2016 11:07 am 

    But Cornucopians are totally elastic when it comes to stretching the facts to fit their version(s) of reality.

  18. JN2 on Sun, 31st Jan 2016 12:10 pm 

    Agree with Short, should be “price inelastic”.

  19. twocats on Sun, 31st Jan 2016 12:14 pm 

    Boat,

    Your lifestyle footprint you describe i think is commendable. I think its comments like the “disillusioned lot” that get you dismissed so easily. Your logic is founded on the rules of this structure and you cling to it even as it crumbles around you. Which is exactly why the teeming hordes will be sorely delayed – even as the lights go dark they will be looting for flat screen tvs.

  20. Boat on Sun, 31st Jan 2016 1:17 pm 

    twocats,

    I don’t cling to anything and have no problem being dismissed when hypocrisy abounds when you blame humanity/governments/systems for your future while and buying the gasoline, driving the roads and enjoying all the fruits of civilization.

  21. Boat on Sun, 31st Jan 2016 1:28 pm 

    Davy,

    Your idea of the world taking the teaming masses out of the cities and each picking up a farm for survival is not a bad dream but ridiculous. Talk about a massive carbon footprint.

  22. Apneaman on Sun, 31st Jan 2016 1:30 pm 

    Das Boat, even if people are hypocrites, that doesn’t change the reality that civilization is a cancer in terminal stage. Moralize all you want, it doesn’t change a thing and is evidence of nothing. Well, it’s evidence that you have no evidence to make a case that everything is awesome.

  23. twocats on Sun, 31st Jan 2016 1:30 pm 

    I have no problem being dismissed [boat]

    well that’s good, because I like to practice my verbal-scathing on you. Back in the day on the block I was quite the dozens man. You’re like a roasting wing chun dummy 🙂

  24. GregT on Sun, 31st Jan 2016 1:33 pm 

    “when hypocrisy abounds when you blame humanity/governments/systems for your future”

    Many of us here are taking our future’s into our own hands Boat. I don’t blame anybody for my future, I am taking personal responsibility for it myself. I will continue to enjoy the “fruits of civilization” for as long as I can, but have cut back dramatically on my consumption. I consider this to be both responsible, and a good practical exercise for the future. You are pointing fingers at everyone else, for what you are doing/failing to do yourself. That would be hypocritical.

    Failure to prepare, is to prepare for failure.

  25. twocats on Sun, 31st Jan 2016 1:41 pm 

    Well said Greg and Apnea. He’s grasping at straws and perhaps becoming a little desperate at once trying to ingratiate himself (personal carbon footprint), while at the same time trying to push emotional buttons to get a rise (delusional lot). It’s hard to tell why he even sticks around considering the abuse he takes. Maybe his Dominatrix is charging too much and so he’s trying to get off on the cheap?

  26. Davy on Sun, 31st Jan 2016 1:45 pm 

    Boater, most of the teaming masses in the cities are screwed. The smart ones will get out while they can. I am talking to them not you. The carbon footprint you speak of is your colorful imagination not mine.

  27. Boat on Sun, 31st Jan 2016 1:56 pm 

    apeman,

    “Das Boat, even if people are hypocrites, that doesn’t change the reality that civilization is a cancer in terminal stage. Moralize all you want”

    Exactly what the moral right and religion has preached for centries. Have I mentioned ya’ll seem like a cult? Ya’ll just have a variety of scenarios that is hellfire and destruction.

    I tend to think humans and the earth are very resilient. Both have a long way to go.

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