Tuesday, May 31, 2011

Real Oil vs. Real Interest

The following chart shows the 10 year moving average of annual inflation adjusted 3-month treasury bill returns.

It is an oil speculator's dream come true. Do you want to know what else is an oil speculator's dream come true? Gregory Mankiw! They can see the unintended consequences of his negative real interest rate theories even if he can't.

Let's add the inflation adjusted price of oil to that chart and also add median values to strip out bubble activity.

I would argue that if short-term inflation adjusted interest rates had been kept nearer to their median value of roughly 1.4% then inflation adjusted oil prices would be nearer to their median value of roughly $40. In other words, oil prices could be more than double their typical value due to interest rate considerations alone.

How is this helping? Do higher oil prices help homeowners make their mortgage payments? No. Are wages double their typical value too? No.

The following chart attempts to show the correlation between short-term interest rates held low over an extended period and higher current prices for oil.

The blue dot shows where we are right now. I also want to point out that over the last year, investors have lost roughly 3% of their purchasing power in 3-month treasury bills. If this had been the trend for the last decade then this chart would imply oil's price would probably be even higher than it is now. I would therefore argue that oil speculators are trying to extrapolate even further into the future and they continue to like what they see.

So here is my theory in a nutshell.

Investors don't rush into hard assets based on temporarily low interest rates. The long continuous grind of lower interest rates on savers and/or speculators eventually makes them hoard hard assets. Those who see the problems coming hoard early and make out like bandits. Those who hoard too late end up being the bagholders someday.

It is that grind that makes them act. It explains the oil, gold, and silver bubbles in the late 1970s and it also explains them now. Keep in mind that it is just a theory and opinion. I could be wrong to think this way. I will once again say that I have absolutely no desire to hoard oil, gold, or silver at these prices though. The lowest lying fruit from those trees was picked years ago. Only the riskiest stuff is left.

I wish I could say when this "ultimate bubble" process will end, but I've been predicting low real interest rates since starting this blog. That said, unless the Fed intends to allow hyperinflation without a fight then there will come a time when they will be forced to act. They won't have a choice, any more than Volcker did.

And lastly, if we actually slide into Japan's deflationary mess then short-term real interest rates will rise. Short-term savers in Japan have not been punished like short-term savers here have. In other words, it might not even take a Volcker.


In my second chart I intended to use the median values but instead used the average values. That has been corrected. I have also inverted the interest rate scale to better show the relationship (hat tip to Rob Dawg at Calculated Risk).

mab pointed out in the comments that my median value still didn't look right. In my haste to make my last correction I accidentally used data going all the way back to 1946. Two wrongs didn't make a right. I think this deserves a personal blunder tag so I'm adding that too. D'oh! I'm fairly sure it is all correct now though.

Source Data:
St. Louis Fed: Spot Oil Price
St. Louis Fed: 3-Month Treasury Bill
St. Louis Fed: CPI-U


Stagflationary Mark said...

I want to make a point clear here.

I am arguing that if long-term inflation adjusted oil prices are roughly what we would expect to see over the long-term, then any excess above that price is almost entirely speculation.

Some of it might be valid speculation. Perhaps the world is running out of oil. Perhaps China will consume all of what's left. However, it is still speculation. It assumes that Mr. Fusion won't come along and/or other alternative energy sources too for that matter.

One might even argue that I am speculating that these are bubbles based on monetary policy. I am! I am! I am!

Mr Slippery said...

Some of it might be valid speculation. Perhaps the world is running out of oil.

Yes, you have to account for actual supply/demand of black gold. Since US oil production peaked in the 70s and a strong case can be made that world production peaked recently, I think some of the price is normal supply/demand, some is negative real rates, and the rest speculation. Hard to point to pure speculation for the delta from your blue dot in the second chart.

As a hard asset hoarder myself, I am convinced that no political will exists in the US to fix our monetary problems. It is so easy to QE your way to bigger social programs and wars of conquest when no outside force is stopping you. Some day, an outside force will cure the US of monetary diarrhea. Until then, flush, wipe, flush. etc.

Stagflationary Mark said...

Mr Slippery,

As a hard asset hoarder myself, I am convinced that no political will exists in the US to fix our monetary problems.

Had I been an investor in the 1970s then I would have believed that too. There was just so much evidence. Speculation in hard assets would have therefore ended up ruining me. I would have been wrong.

I truly believe that Ben Bernanke is trying to keep inflation (as seen in the CPI) stable (at a low but predictable pace). For the most part he has succeeded in that goal (if little else). He cannot afford to let long-term inflation expectations rise because hyperinflation would completely ruin the banking system and any justification for the Fed's existence.

So we'll just have to see what happens in the future.

In any event, hoarding gold and silver at these prices makes far less sense to me than hoarding toilet paper at these prices. There have been a distinct lack of toilet paper speculators. If nothing else, toilet paper represents an extreme relative value.

May 31, 2011
Paul Volcker: The Fed Will Soon Have To Tighten Monetary Policy

Note the word "forced" within the link. If inflation picks up then the Fed must fight it at some point or we will hyperinflate.

I am a believer in that "if/must" theory. It is an "if" though. If inflation does not pick up then I doubt oil investors will like that outcome much better though.

mab said...


Just by eyeballing the real median oil price of $28/bbl looks low.

Stagflationary Mark said...


You are right. In my haste to fix it the first time I accidentally used the data going all the way back to 1946. It has been corrected.

Good eye!