Stagflation
If emerging market stocks run another 20%-30% from here, I am pretty sure oil will follow. The same logic that investors are using to bid up asset prices, liquidity from the Fed, can and is being used to bid up oil prices.
The thing is, there is no theory to figure out what the price of a commodity should be. For stocks, one can use DCF or some other intellectual justification. What should one use to figure out the price of oil? Supply is more than demand today. So should oil fall to $50 or $40. Why not $10? An economist will say - well the price of oil should be such that demand is met over the next few years and oil exploration companies are able to earn their cost of capital. If oil companies make excess profits, then price of oil is high. Needless to say, this logic has zero practical applicability.
Markets are open right now for both equity and debt, and the Fed will be hoping that investors calm down a bit. Because if they don't, by their very actions, investors will cause inflation to happen. It might not happen in the US as much where commodity prices are not a big part of CPI, but it will definitely happen in emerging markets like India.
Return of the Friedmanites
Suppose commodity prices keep going up. The closed mines will open up as soon as selling price crosses their cost of production. However, because demand would not have come back to the same degree, their production will go into inventories - unless the cost of production also moves up so that the mines remain unprofitable. That would require some giant scheme so that the general price level in the world economy goes up. In particular, wages need to go up, which doesn't seem likely looking at the state of world affairs.
So, production goes into inventories. There are no end buyers. Do prices go down, or bulls keep arguing that China will take care of the inventories in a year? Does dollar weakness keep commodity prices high which leads to stockpiling of inventories?
The key to inflation is not output gap. It is commodity prices, at least in emerging markets like India. The last year was the year of Keynesians. I think Friedmanites are going to get an opportunity to strike back very soon. How exactly we get inflation, I am not very sure. Investors are taking Libor + 50bps funding provided by the brokers to take a flyer on everything risky.
