Thursday, February 8, 2007

Oil Prices and Interest Rates

Energy is included in every product and service and thus its price greatly influences inflation, which in turn affects interest rates. We logically expect interest rates to rise and fall significantly with the movement of oil prices and that is precisely what happened - at least until 1998.

The chart below shows the price of oil and the yield of the 10 year US Treasury bond (annual averages). There is a clear correlation in their movement until 1998 but a sharp divergence afterwards. Mathematical correlation is a very high 0.77 (max. = 1.00) between 1970 and 1998, but thereafter it goes to -0.37, i.e. interest rates kept going down even as oil prices soared. Yet another interest rate conundrum?

Not really: the Chinese export juggernaut has kept US consumer inflation low, as the ready availability of ultra-cheap labor and the yuan/dollar currency peg are keeping a lid on final prices (at the expense of the domestic US manufacturing sector, of course).

How long can this go on? Until China creates a substantial consumer-oriented middle class of its own, one that demands a better standard of living, i.e. higher real wages and better social benefits like vacation with pay, medical care and state pensions. This will not only raise labor costs and export prices, but it will further increase China's oil demand - at which point it will be off to the races for US consumer inflation.

Unless, of course, final consumer demand in the US collapses first from a debt implosion. Either way it will not be pretty - Goldilocks is a fairy tale, after all.

No comments: