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Oil, Inflation and the Dollar

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By Washcomp
October 14, 2009

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We, on METAR have been discussing a number of parallel parts of the same system as if they were "stand-alone" issues:

1) Inflation/deflation
2) The value of the US dollar measured in other currencies
3) The price of oil (I am going to ignore the price of gold for now as it will confuse things)
4) The Fed and it's responses to our issues
5) The employment (as reflected in the unemployment) rate
6) The standard of living of the average American

Let's assume that the inflation, deflation thing is at a steady state right now of zero (there are some who claim it's on either side of zero, and it may be, but it doesn't matter that much for the purposes of this discussion).

There are few "givens":

1) Inflation/deflation tends to affect our standard of living, but is not as important (other than its affect on cash savings) as a parallel compensation (wage or investment return) rate to the individual. If the cost of a loaf of bread doubled, but your wages (ignoring taxes) doubled, then bread would (on a relative basis) cost you the same.
2) Based on this premise, inflation (or deflation) have little effect on the non-debtor if wage rates keep up/down in proportion. A debtor enjoys inflation because it allows debts to be paid off in the future with devalued currency.
3) The price of oil, while measured in US dollars, tracks a combination of supply/demand, "speculator" interests, the ability of nations to manipulate the prices for their own interests (both on the supply - think OPEC, and the demand side)
4) The price of a currency (in this case, the USD) is a ratio to other currencies based on the domestic interest rate (higher rate would support a stronger currency), the perceived inflation rate (inflation would favor a weaker currency) and the risk factors (of political or fiscal problems causing a devaluation).
5) A weaker currency favors exporting, but causes a pressure which tends to increase commodity pricing, including oil prices

This basically defines our starting point of where we are today.

The Fed's ability to manipulate the economy is based on a number of "tools" they have available:

1) They can increase the interest rates they pay banks for deposits at the Fed. The higher this rate, the less likely banks are to lend their money in a risky environment. This currently is being used to re-capitalize banks.
2) They can decrease the interest rate they charge banks for loans (currently at close to zero). While, on the surface, this appears to inject money into banks which can be loaned, in reality the money can simply be re-deposited at the Fed for an arbitrage play or used for other activities (such as investing in the equity or bond market which offer the potential of higher returns. I believe this may be behind much of our current equity rally.
3) They can, through "currency swaps" with other nations affect the price of the US dollar compared to other currencies.
4) They can support lower interest rates by buying US government debt or the reverse, if they wish)

We have a major drop in employment. This is best demonstrated by the cumulative 26% drop in federal withholding taxes, rather than the reported 9.8% unemployment figure (both of which ignore new entries into the potential labor force who have not previously been employed). While our social safety nets (unavailable in the 1930's) are supporting much of this additional "weight", the results are an exploding amount of cumulative federal/state/city debt. Not only do these entitlement programs have to be funded, but the tax base (as pointed out simplistically by the drop in withholding tax) has eroded dramatically. Our collective standard of living has been diminished, both by the reduction of the value of assets owned by the average American (or of their increase of relative indebtedness compared to assets if they have a mortgage) as well as a drop in their current average income. We also must take into account the additional $1T of ALT-A and ARM mortgage resets expected in 2010-2011, not to mention a huge amount of required refinancing for commercial properties which are currently losing their revenue bases due to our current recession. Even in the absence of the inflation/deflation argument, this limits the Fed's option to allow the increase of interest rates any time soon.

Now we get to oil:

Oil is valued (for the time being and likely for a number of years to come) in US dollars. As the US dollar drops, if the price per barrel remains constant, we in the US do not see any change in price at the pump. OTOH, in terms of other currencies, oil producing states see their revenues declining (we are back to the argument for each of us to consider our financial results in global terms, but that's another thread). Other consuming countries, when evaluating oil prices in their own currencies see oil declining if the price is stable in terms of US dollars. From a geopolitical point of view, while some of the oil exporters (Saudi's for example) might, for a short period of time be sympathetic, others (such as Russia, Iran, Venezuela) might not place our interests above their own national prerogatives. Oil prices have been further complicated by a bubble/bust within the last year or two (the bust portion of which was, in my opinion orchestrated by the world's combined central banks to prevent complicating their dealing with other issues).

We have traditionally associated oil price increases as a sign of inflation. If oil prices increase while we are still facing our current issues, my contention is that it will actually be deflationary. The additional cost will be removing money from the money supply without adding any incremental benefit. Because of our dependence on the automobile for transportation (especially outside of central urban areas), an increase would further reduce the standard of living for the average American.

There have been press reports of a "green shoot" that the savings rate among Americans is once more declining. This is taken as a sign that Americans are again spending at the retail level. My take is that so many Americans are out of work that many are being forced to dip into their savings in order to maintain their (now lower) standard of living - same data, different interpretation. An increase in the price of gasoline/heating oil will increase pressure on our economy.

From an export standpoint, an increase in the price of raw materials (in dollar terms) will blunt some of the trade advantage we gain from a lower dollar (Caterpillar has already announced price increases).

The "war" for oil prices between the producers and the consumers will continue. As we (the collective consumers) become more driven to reduce the usage of imported oil, the more the producers will realize that while their supplies are finite, the commodity will potentially see lower demand even if the world economy picks up. This will change their collective attitude toward "optimizing" the supply side of the equation. I'm not clear how this new metric will affect the multinational oil companies who are going to be pressured on both the supplier and the consumer side of the equation.

If the world economy picks up, while commodities may continue to be priced (for convenience and because the world economy is flooded with USD reserves) in US dollars, the prices of those commodities in the US will push upward and create an additional headwind on our standard of living. While still priced in dollars, there is a strong probability of a de-coupling of commodity prices from the status of the US economy.

What the future holds:

Based on the above, the Fed will fight to hold interest rates low for much of the next two years. Their success will be determined by the continuance of the USD being used as a standard trade token, as well as the perception of potential bond holders of the safety of their investments. Strategies of nations are complex in this regard. The Russians apparently made purchases of T bills at the last auction to bring down the price of the soaring Ruble (so our bonds are now being used as boat anchors for stronger currencies :-). If possible, I believe the Fed would like to keep the rates low through the next presidential election and allow inflation to eat away at the value of our county's debts (both private and public). OTOH, this inflation cycle is only palatable if the employment rate is much higher than it is now or it will reduce the savings and investments (such as they are) of the average American to shambles. If they are forced to raise rates prematurely (say in 2011-2012), it will likely cost the incumbent president the election, regardless of other factors (last time this took place was with President Carter) and the Fed would be seen as the cause. If they can pull off the hat trick of raising employment, then followed by inflation coupled to low interest rates through the election, then 2013 will see a repeat of the 1980's with double digit interest rates to stabilize things again (forcing a short, deep, hopefully "controlled" recession).

The three "tells" of where we are in the above:

1) Value of the dollar (grossly measured by the "dollar index")
2) Employment figures (as represented by the Treasury department's reporting of payroll withholding tax)
3) (New addition) the price of oil

Of course the above ignores "black swans" and is subject to change without notice :-)

Jeff