The Fed's Oil Price

by: economist88

Summary

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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