Kent on Current Events: The Big (Oily) Crunch

No, this isn't a public service announcement about the dangers of eating KFC. This is about the credit crunch, inflation, and how it all relates to the price of oil. First of all, I must congratulate the McCain camp by dissociating themselves from former economic advisor Phil Gramm, who believes the U.S. is a "nation of whiners" in a "mental recession". I agree that it's not very productive to whine about losing your home to floods and foreclosures, losing your job and paying twice as much to fill up the gas tank compared to last year--but the recession part is not exactly mental. I stumbled across a stunning correlation the other day--that oil prices are actually linked to inflation. Please excuse my facetiousness, but this is why the U.S. is in a recession, even if the numbers do not show it by definition yet. To be honest I did not realize how close the historical link between oil prices and interest rates has been until I charted it up myself.

The Correlation
Everyone knows when gas prices go higher, so too does the cost of everything since so many of the things we use are either made from fossil fuel and its derivatives, or transported by them. Everything from clothes (polyester) to electronics (plastics) to groceries (diesel for production & transport) is heavily dependent on hydrocarbons. There is usually a price-lag of months to even years because it takes time before these costs reach the consumer in many of these products, particularly when companies use price contracts and hedging to ensure delivery of their commodities and parts at a predictable price for as much as 6-12 months in the future. Employees are given higher wages to compensate for the increasing price of pretty much everything, and thus the cycle of inflation continues.

(click for large detailed view)

It looks to me like the mortgage crisis and subsequent Fed rate cuts in late 2007 and early 2008 played a very significant role in the exponential oil price increase since. The big question is whether the oil price/interest rate link is causal, effectual or casual. It is obviously not effectual because interest rates were low since 2000 when oil prices started to rise. So high oil prices either cause high interest rates or the link is simply casual (i.e. inflation and interest rates tend upwards with high oil prices but not necessarily with any definitive proportionality). I dearly hope it is the latter because otherwise one would expect the cost of borrowing to increase beyond the 20% seen in the oil price shocks of the seventies (which seems unlikely). In either case, it certainly does appear that the cost of borrowing is increasing despite the Federal Banks' decision to keep their interbank lending rate at historic lows. The analysts' consensus is that the Fed will raise rates in late 2008 or early 2009 although the central bank likes to appear apolitical by avoiding rate changes that affect the economy near an election. Banks are not waiting that long to tighten their wallets though--mortgage rates in the United States have increased 10% from January to June 2008 even though the U.S. prime rate has decreased 23% year to date. Fernie, Freddie and IndyMac are more bad news on that front. With the amount of mortgages going delinquent, the banks that backed them going broke, and investors deciding to move their money to the home mattress 'bank' (or at least outside of U.S. markets), higher interest rates would mean we haven't seen the bottom of the crisis just yet.

Who Takes The Blame?
I've already discussed the potential reasons for the increase in oil prices (market speculation, rate cuts and the declining USD, lack of supply, increasing demand from developing countries and re-valuation of the commodity)--there is still no consensus on which of these factors are most important.

There is more agreement on the credit crunch side to this coin:

In the early 2000's, interest rates were at 35-year lows in the face of the dot-com bubble burst of March 2000 and the events of September 11th, 2001.
In June of 2002 the Bush administration unveiled a seemingly well-intending policy to "close the home ownership gap between minorities and non-minorities". It encouraged mortgage brokers to make the lending process easier with "less paperwork" and provided both tax credits and down payment assistance (read full policy).
Some white-collar criminals saw these factors as an opportunity to make money through the regulatory loopholes and predatory lending practices.

I don't think I need to explain what happened next although I will share a very accurate satirical depiction that many of you will have seen via email:

The Subprime Primer (credit unknown).

As far as the Fed goes, it is true that they failed to keep a close enough eye on lending practices and left too many regulatory loopholes open. Many have called on Ben Bernanke to raise interest rates to stem inflation and bring back the value of the U.S. dollar, both of which will lower oil prices. However, it seems clear that even at the current low interest rates, big banks have begun failing. As I've said, this really does seem to be the stagflation dilemma.

What Next?
For U.S. policymakers, they need to find a way to bring down oil prices without raising the interbank lending rate--and quickly. I have no idea how it can be done but they need solutions at this point rather than passing around nonconstructive blame.

For investors, market volatility is likely to continue assuming the policymakers fail to find an answer to the oil price and credit crunch problems. Investing in turbulent times can still be profitable, even though it becomes much more difficult for the average person. Basic goods and services that are based on need rather than luxury items are always good investments in a bear market. Wal Mart's shares are up 20% YTD as consumers move towards discount retail items. Gold and silver are always good hedges against high inflation, although I'm not sure if they are overbought at this point. Shorting positions are obviously good in a bear market--but this is only for experienced investors due to added complexities. And most importantly--minimize debt at a time when the cost of raising capital is likely to increase.

Of course the Canadian economy is in much better shape fundamentally than our neighbours to the south, although our economy is certainly not isolated from that of our biggest trading partner. I would be very interested to hear any comments and opinions of the state of the Canadian and/or U.S. and/or global economies from any readers. My next post will speak specifically to Alberta's economy--which currently holds the economic engine of Canada fueled by the oilsands.

Further Reading