In previous PolicyMic articles, I examined the dynamics involved in oil prices and by extension, gasoline prices, since the price of crude is the chief determinant (about 65%) of gas prices. Here, I will explain the U.S. Federal Reserve’s role in pumping up prices at the pump.
When the global economy underwent its complete free fall in the latter half of 2008, the Federal Reserve responded in predictable fashion. Consistent with the Greenspan/Bernanke approach to recessionary events such as the bursting of the dotcom bubble in 2000 and the 9/11 attacks, the Fed slashed interest rates, and as an added measure, purchased massive amounts of U.S. treasury bonds and (toxic) mortgage-backed securities from ailing financial firms. The goal of this latter approach, termed “quantitative easing,” was to provide liquidity to major financial institutions by purchasing their mortgage paper, as well as treasury notes in an effort to drive down their yields and dampen “safe-haven” investing. Concerned about a credit squeeze, the Fed has flushed banks with cash and allowed them to borrow at rock bottom interest rates of 0% to 0.25% in an attempt to spur lending. In late 2010, the Fed even initiated a second round of QE.
Conventional wisdom says that if QE and zero interest rate policies (ZIRP) “work,” lending and consumption will rise, and ultimately employment will too. Although higher prices would result from these policies, they would be more than offset by growth in employment and income. While the effectiveness of QE and ZIRP in reviving the economy has been hotly debated, one thing is clear: the Fed’s policies have succeeded in boosting asset prices across the board, and that includes oil. (In fact the chart in this article shows a very strong correlation between Treasury purchases by the Fed, and a leading commodities index.)
Take a look at the following chart, which displays the price of the benchmark West Texas Intermediate (WTI) crude versus the trade weighted value of the dollar. Notice the inverse relationship, as well as the drastic drop in dollar strength in the wake of each round of QE.
We see a similar relationship at work between the Dollar Index, which measures dollar strength against a basket of six major currencies, and net non-commercial long (meaning, buy) positions in WTI.
"Non-commercial" in this case refers to buyers who have no intention of taking delivery of the oil they're buying. These investors include banks, hedge funds, and individual traders, as opposed to the physical hedgers who buy oil futures contracts in order to lock in a fixed price and expect to take delivery.
Whenever a central bank debases the value of the currency, the tendency among investors is to exchange that currency for something else: equities, precious metals, and commodities, such as oil. And this is exactly what we have seen in the U.S., as the dollar has lost value not only in terms of these assets, but relative to other currencies as well, as the orange line above shows. The long positions highlighted by the blue line represent those investors who, disconcerted by the Fed's loose monetary policy, decided to dump their greenbacks and pile into crude oil.
One can blame the "speculators" for piling into oil and other commodities, thereby driving up their prices. But the reality is that their actions are merely a logical response to what has been the prevailing policies of the Federal Reserve under the last two presidential administrations. Given the bipartisan nature of the country's monetary policy, this is surely cause for concern.
Photo Credit: Medill DC