Thursday, June 2, 2011

The Fed and gas prices

Last week Austrian economist Robert Murphy testified before Congress on the Fed's role in raising gasoline prices.  Here is part of what he had to say:

After hitting record highs in the summer of 2008, the price of crude oil crashed amidst the financial crisis and slowdown in world economic growth. After hitting a low of $33.87 per barrel on December 19, 2008, the benchmark price of a Cushing oil futures contract had risen to $96.91 by May 17, 2011. . .

There are two main routes through which Fed policy could have influenced oil prices (quoted in dollars). First, the Fed could have caused the dollar to depreciate against other currencies. Second, the Fed could have raised the price of oil relative to most other goods and services. In the remainder of this written testimony, I will first lay out the extraordinary interventions of the Federal Reserve in the wake of the financial crisis, and then turn to each of the two possible connections to oil prices.


The Extraordinary Interventions of the Federal Reserve

The Federal Reserve has engaged in several extraordinary measures since 2007 to deal with the developing financial crisis. The Federal Reserve Bank of New York has compiled a timeline of these specific interventions. In addition to cutting the federal funds target interest rate to virtually zero, the Fed has expanded its balance sheet by purchasing mortgage-related derivatives and Treasury debt. . . .

[F]rom the creation of the Fed in late 1913 up until September 2008, the monetary base grew by a little more than $932 billion. From September 2008 until the present, the monetary base has grown by an additional $1,595 billion. The Federal Reserve has clearly embarked on unprecedented injections of liquidity into the financial system during the last few years. . . 

Crude oil is traded on a world market. If the dollar falls against another currency, such as the euro, then either the euro-price of oil has to fall, or the dollar-price of oil has to rise, to eliminate arbitrage profits. From its peak in March 2009, the dollar has fallen 17 percent against other major currencies. Therefore, holding everything else constant, the dollar deprecation alone from early 2009 can explain a 20.5 percent increase in oil prices (quoted in dollars).  [Emphasis added]  Put differently, the oil price quoted in (say) Japanese yen has not risen as much since early 2009 as it has in U.S. dollars. . .

In addition to causing oil prices (quoted in dollars) to rise because of a weakening dollar, Federal Reserve policy may also affect oil prices more directly to the extent that it has caused investors to shift some of their wealth into commodities as an “inflation hedge.”  For example, since September of 2008, gold and silver prices have increased some 80 percent and 210 percent, respectively. A certain segment of investors and the general public are very concerned about the future purchasing power of the dollar, and have invested in the precious metals to protect themselves from potentially large future price inflation.

More generally, some investors may be turning to other commodities (including oil) thinking that they will provide a relatively safe store of value, in the event that the dollar and other paper currencies weaken in the future. However, although this theory has a surface plausibility, in practice it is difficult to distinguish it from an explanation that oil’s price rise is due to “the fundamentals,” i.e. a genuine growth in end-user demand for oil relative to the increase in output. . .

Conclusion

If policymakers want to lower the price of gasoline for American consumers, they have several options. Most obvious, they could reduce federal and state gasoline taxes. They could also expedite the regulatory and permitting process for the development of offshore and other domestic oil resources. Finally, with respect to the Federal Reserve, to the extent that a tighter monetary policy would strengthen the dollar and reduce investor concern about future price inflation, we would see lower crude oil prices and hence lower gasoline prices. It is notoriously difficult though to estimate the quantitative impacts of these policies, because market prices are influenced by so many different factors.

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