A Stagflation Sideshow: The Wall Street Journal’s Flawed Theory of Oil Prices

Yesterday’s Wall Street Journal editorial “The Stagflation Show” (June 9) has a graph showing the price of oil generally rising while the fed funds rate was falling (if you don't look too closely at flat or falling oil prices from November through February).

The conclusion is that if the Fed had not cut interest rates since last September the oil price would not have go up. Perhaps so, but the most obvious reason for any link between Fed easing and oil prices is not mentioned at all. And the stated reason (a “dollar rout and commodity boom”) is at odds with the facts. The timing is way off.

The most obvious connection between oil prices and Fed policy is cyclical.

There have been nine big spikes in oil prices since the 1950s and every one of them was followed by a U.S./world recession within a year.

Every recession, in turn, was followed by a huge drop in the price of crude oil. West Texas crude fell by 44-71% in the wake of the last three recessions.

If the Fed had left the interest rates on bank reserves at 5 ¼% -- the U.S. would very likely have led the world into a significant recession long before now. And a U.S./world recession would indeed have pushed the oil price down. But that is not what the Journal editorial page seems to be suggesting. Instead, they blame the Fed for a “dollar rout and commodity boom.”

The big spike in oil prices since early March happened when the dollar was not falling and also when prices of many non-energy commodity prices were falling. There has been no dollar rout and a no generalized commodity boom since February (when oil fell as low as $87 even as food prices soared).

The Fed’s trade-weighted index of the dollar’s value against 26 currencies was 95.77 in March and 95.83 in May. The narrower index of 7 major currencies was 70.32 in March and 70.75 in May.

From March 4 to June 3 The Economist index of 25 commodity prices -- excluding oil --fell by 7.8% in dollars (from 271.9 to 250.6) but by only 5.7% in British pounds. The dollar price of wheat fell by 40%, cotton by 26%, and prices have also fallen sharply for livestock, lumber and most industrial metals. This is a "commodity boom"?

It is true that lower short-term interest rates have made it cheaper for producers and "speculators" to hold crude oil off the market (e.g., in tankers or in the ground) if they expect a higher price in the near future. But speculation in the futures market can’t keep prices in the cash (spot) market higher than the market will bear. And the world does not have an unlimited budget to pay more and more for petrochemicals and fuel. As firms cut back or shut down production in energy-intensive industries worldwide (U.S. airlines are just the most obvious example) the demand for oil can drop quickly.

Oil above $130 involves a massive transfer of income away from oil-importing countries, raising their cost of living and cost of production. That greatly increases the likelihood of a significant economic slowdown or contraction in most oil-importing countries, even India and China. And that, in turn, always causes the price of oil to collapse.