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Are surging oil prices inflationary or deflationary?

That’s the question we seek to answer in today’s Daily Reckoning.

Most people seem to think that higher oil prices are inflationary, citing the oil shocks of the 1970s as evidence. But it’s not that simple. The ultimate effect of higher energy prices on consumer prices depends on a number of factors.

Back in the 1970s, higher oil prices led to stagflation – high inflation and low economic growth. This was largely due to the fact that labour unions were much stronger then and could bargain for higher wages to offset the impact of rising energy costs.

And importantly, these higher wages came without offsetting increases in labour productivity. So, higher wages (meaning higher demand) without an increase in the production or supply of goods and services, led to rising consumer prices.

Fast forward a few decades and the 2000s saw a dramatic increase in the price of oil. In the late 1990s oil was trading around US$10. By mid-2008, prices peaked at US$150. But we didn’t see a major inflationary breakout.

There were a number of reasons for this. Firstly, inflation statistics were doctored to keep interest rates low. Low interest rates got the masses addicted to debt, which had the effect of increasing their purchasing power.

So instead of demanding a pay rise to cope with higher costs at the pump, the consumer added to their debt pile and bought an SUV. Rising asset prices made people feel wealthy and so saving a portion of income no longer factored into most households’ financial plan.

The process of globalisation added to the restraint on wages. Outsourcing lowered labour costs, and kept the price of tradeable goods and services down. This had a ‘dis-inflationary’ effect.

So, higher oil prices do not always translate into higher consumer price inflation. But that doesn’t mean the impact is benign. If you’re a net energy importer like the US or Japan, you end up paying for it in some way or another – usually via an increase in debt.

Which brings us back to the question at hand. Will the recent surge in oil prices have an inflationary or deflationary impact on the global economy?

Our guess is that, if sustained, higher prices will drag global growth lower and exert a deflationary force on prices – especially asset prices. Not straight away. You’ll need to see prices remain high for probably 4-6 months or so before it starts to bite.

But the bottom line is that higher oil prices act as a tax on net energy importing countries. The more you need to spend at the bowser, the less you spend elsewhere.

And in the traditional consumer economies of the West, the days of going to the bank and increasing your home equity mortgage to supplement your diminishing income are over.

Not that the Federal Reserve realises this. Bernanke is singing from the same hymn book as his predecessor, stuffing commercial banks full of reserves in the hope they will lend them out to people.

But it’s not working. There may be plenty of inflationary fuel in the US banking system but no one has got a light.

Ironically enough, it is due to the Fed’s actions that oil prices are as high as they are. In an attempt to create inflation, Bernanke could well tip the global economy back into deflation.

The reflation effort after the bust has not done much for ‘Main Street’. Measured properly and realistically, the unemployment rate in the US is probably somewhere closer to 17 per cent.

(In the US, if you give up looking for a job for a few weeks – hey presto – you’re not unemployed.)

But the reflation effort has done plenty for Wall Street. Speculators have pushed up the price of commodities everywhere. Oil has moved from below US$40 in 2009 to around US$100 now.

Rising food prices have triggered unrest in the Middle East. The people have had enough. Again, it is ironic that the protests have occurred under dictators that have the implicit or explicit backing of the US.
Is this what it looks like when a global hegemon’s power diminishes? Attempts to fix one problem just produce more in totally unexpected ways. The law of unintended consequences is in full flight and Bernanke doesn’t have a clue. Or if he does, he’s not letting on.

Rule number one of all central bankers and people in positions of false power: It’s always someone else’s fault. Never say sorry, never admit culpability, never accept responsibility for your actions .
This rule allows actions to be taken to the extreme. And at the extreme, Bernanke has helped to create massive inflation in commodities that will ultimately manifest in deflation in the real economy.
Then we’ll see QE3 and QE4 as insanity starts to set in…

Welcome to the twisted world of Ben Bernanke’s monetary experiment. It’s going to be a wild ride.

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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