The U.S. Dollar, Oil and the Fed

My colleague John Russell, the Guide for the Forex site for About.com recently discussed the role of the U.S. dollar in high oil prices:

Many times, no one comments on the effect that the falling value of the dollar has on oil prices since oil is priced in dollars. The rising price of oil is likely to be multiple factors working together. The dollar losing value, some effects of speculators, growing demand. Unfortunately, there is no easy one off fix for the problem.

Whereas a recent Globe and Mail article examines a single factor - The Fed:

On the other hand, the U.S. Federal Reserve - the same central bank currently complaining about inflation that has risen as a result of higher food and energy prices - could be the source of the latest upswing, thanks to interest rates that are currently lower than the rate of inflation.

"Looking back 30 years, we find that a 1-per-cent reduction in real interest rates results in a 17.5-per-cent increase in spot commodity prices 10 months later," Francisco Blanch, commodity strategist at Merrill Lynch, said in a note to clients. "This estimate suggests that loose monetary policy has played a much more important role than speculators in the recent commodity price rally."

The low interest rates mean that producers (mostly governments like Saudi Arabia) have an incentive to keep oil and mineral deposits in the ground, since they can't get a very juicy return on their investments in other assets.

The Globe article and John's comments are a good illustration of how various economic indicators interact with each other.

The Fed loosens monetary policy. This causes:

• The U.S. dollar to drop. Since oil is priced in U.S. dollars, this appears as a rise in oil prices.



• Inflation due to an increase in the money supply. But where all this new money going to go? As one of my colleagues (who is heavily invested in commodities) likes to say - if you had money right now, where would you put it in 2008? Real estate? Bonds.. when real interest rates are negative (or close to it?) Stocks - when consumers are slowing their spending? It (according to his logic) has to go to commodities. Other channels, ceteris paribus, look less attractive. I am not sure I totally buy into this logic, but it does have some intuitive sense.



• The increase in commodity prices raises the value of the currency of commodity producing countries, such as Canada. So the U.S. dollar falls relative to the Canadian one. But since oil is priced in U.S. dollars, this again appears as a rise in oil prices.

If interest rates start significantly rising in the U.S. (to cut inflation off at the pass), it will be interesting to see what happens to the price of oil and other commodities.