Sunday, April 17, 2011

Clarifications About Monetary Policy & Oil

In hindsight, I realize that I unintentionally might have given a partially misleading impression in the preceding post.

I quoted Steve Hanke's estimate of the effect of a move in the euro/dollar exchange rate on the dollar price of oil and then treated it as correct or assuming that the real effect is at most the double. Let me then clarify that Hanke's estimate could very well be true if we are talking about exchange rate movements in an isolated or ceteris paribus context.

However to the extent that the drop in the dollar is caused by "loose" Fed policy, I do believe that the effect on the dollar oil price is a lot higher because it not only raises it through the exchange rate mechanism but also because the price of oil, like prices of other commodities, is much more flexible than other prices. Indeed, it could in fact be even higher than 1, which is to say that "loose" Fed policy could very well increase the dollar oil price more than it lowers the dollar's exchange rate against other currencies including the euro, and so increase the price of oil even in terms of euros and other currencies.

On the other hand, it should be noted that the 7% appreciation of the euro since mid-February doesn't just reflect  "loose" Fed policy, but also a "tight" ECB policy. Because since mid-February, the British pound has appreciated less than 1.5% against the U.S. dollar, the yen only about 0.5% and the Canadian dollar only about 2.5%.

Thus, even if we say assume that a weakening of the dollar caused by the loose Fed policy increases the value of oil compared to U.S. dollars by 3 times the amount it increases value of foreign currencies compared to U.S. dollars (an assumed effect which thus is 6 times Hanke's estimate), we would still at most only be talking about a 5-7.5% effect, something that pales in comparison with the overall 30+% increase in the dollar price of oil since mid-February.

Furthermore, just as "loose" Fed policies has a price increasing effect, so does "tight" ECB policies have a price reducing effect. Considering that, it should be clear that monetary factors account for a much smaller part of the oil price increase than the war in Libya that has been prolonged by foreign intervention.