Monday, February 28, 2011

Oil prices on the rise--inflationary or deflationary?

Nothing.  NOTHING! disrupts the global economy faster than rising oil prices.  The reason is simple--oil (in its many refined manifestations) is the specified fuel for a host of critical applications.  This isn't an "addiction" (with all the BS that word inspires) this is an industrial specification.  Turn off the oil and the global economy grinds to a halt. Without a massive rebuilding of the oil-fueled infrastructure so it could run on some other energy source, there is literally no escaping the need for oil.

Therefore, when the price of this precious substance goes up, folks have no choice but to pay the bill.  And because oil figures into such a wide assortment of market goods like food, everyone who can raise their prices to cover their oil bills will do so.  In this way, raising oil prices will automatically raise the prices of almost everything else.  When prices for everything goes up, economic commentators start screaming about "inflation."

And they would be right except for one thing--inflation cannot break out unless there is a mechanism to raise incomes to cover the higher prices.  If incomes do not rise, higher oil prices will inevitably mean that folks will simply buy less of something else.  Higher energy bills are deflationary because they crush demand.  And when demand shrinks, the folks who want to raise prices to cover their fuel costs cannot do so.  Enterprises start eating losses which if done over a long enough period of time, will put them out of business.  And failing businesses really ARE deflationary.

So the answer to whether higher oil prices are inflationary or deflationary, the answer is obviously BOTH.  In fact, in the 1970s we called this problem "stagflation" although the mechanisms for stagflation were usually misunderstood by Predator Class economists of both left and right.

The markets became slaves to oil prices this week as fears of Middle East contagion sent prices skyrocketing almost 20% higher in 5 days. After nearly breaching the $120 level in overnight trading on Wednesday Brent Crude made a dramatic reversal before settling almost $10 lower just hours later. Brent crude is now sitting at $111 – almost 10% higher for the week.
A Simple Rule Of Thumb Regarding Oil And How It Impacts The Economy
From Deutsche Bank, this is useful:
According to our analysis, a $10 increase in oil prices translates into roughly a 25 cent increase in retail gasoline prices. Every one penny increase in gasoline is then worth about $1 billion in household energy consumption. (In decimal terms, it is actually $1.4 billion.) Therefore, a sustained $10 increase in oil prices translates into $25 billion in additional household energy spending. Assuming this price rise crowds out spending elsewhere in the economy, effectively acting as a tax, means that a sustained $10 rise in oil prices reduces annual real GDP growth by 0.2%. more
David Rosenberg makes some interesting comments in his morning note regarding the price action in US Treasuries. He cites the rally as a sign that the world is concerned about the deflationary shocks from rising oil prices:
“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.”
I think Rosey has this one spot on. The risk of rising oil is not a hyperinflationary spiral, but rather a deflationary spiral. Oil price increases are cost push inflation of the worst kind and for a country still mired in a balance sheet recession that means spending gets diverted which only gives the appearance of inflation in (highly visible) gas prices while creating deflationary trends in most (less visible) other assets (have a look at today’s Case Shiller housing report for instance).
The environment is not really so different from what we were experiencing in 2008. What we have in the USA is an underlying balance sheet recession being papered over by government deficit spending and very easy monetary policy. The math behind our economic plight is quite simple. Since we are running a -3% current account deficit the government MUST spend to the tune of 3%+ of GDP if the private sector desires to save. And that’s exactly what is occurring. In fact, the 10% deficit is allowing the private sector to save quite a bit (roughly 7%). Make no mistake, the deficit spending of the last 2 years is what has generated recovery. This is far from organic growth, but as we learned in Japan and during the Great Depression, the alternative is to risk something worse. Unfortunately, our implementation of the recovery plan has been mangled at several steps along the way so it is primarily Wall Street that has benefited while Main Street continues to suffer. more
Why Higher Oil Prices Are Deflationary, Not Inflationary
Cullen Roche, Pragmatic Capitalism | Feb. 27, 2011, 8:08 AM 
There’s been a lot of good commentary in the last 24 hours regarding the deflationary impact of higher oil prices. Much of this discussion has been based around its impacts in Japan, however, it is applicable to the USA as well. In a piece this morning FT Alphaville commentary from Macquarie and JP Morgan regarding this effect:
As Macquarie Securities noted:
“We disagree with the view that deflation means Japan is the one country to benefit from higher oil prices. In the previous commodity boom, profits peaked in 1Q07 and domestic demand in 2Q07 as higher commodity prices pushed the economy towards recession well before the Lehman’s collapse.”
Masamichi Adachi, economist at JPMorgan in Tokyo, reinforced the point:
“Some commentators argue that the rise of commodity prices is welcome in Japan, which is suffering prolonged deflation. We disagree with this view. While the rise in food and energy prices may increase households’ inflation expectations, it does not mean that they can expect higher wages in the future. Actually, in a deflationary environment with considerable slack, the opposite will likely happen as the profit squeeze will weigh on wages, further restraining labor income and consumption. The deterioration in the terms of trade—resulting from a rise in import prices and a fall in (or flat) export prices—may be the drag on domestic demand, which is still sluggish and fragile.”
That’s right. For a nation suffering a balance sheet recession the likelihood is that higher oil costs will serve only as a tax. This supply shock results in depressing aggregate demand and furthering the likelihood of deflationary pressures. Paul Krugman elaborated on this:
“So, does a rise in food and energy prices do anything to alleviate these (deflationary) problems? No. In fact, it makes them worse, by reducing purchasing power. So while the commodity surge may temporarily lead to rising headline prices in Japan, the underlying deflation problem won’t be affected at all.”
That’s exactly right. At the end of the day rising oil prices will only crunch consumer balance sheets further which increases the likelihood of recession. more

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