The collapse in oil should make the Fed more dovish, not less

There has been a lot of talk surrounding the collapse of oil prices. On one side are the optimists who focus on the income transfers to consumers. On the other are the bears who insist that the ongoing oil shock is symptomatic of a weakening global economy. Both camps have portrayed themselves as contrarian, with Gavyn Davies of the Financial Times going so far as to say that gloominess is always more popular than bullishness. The good people at Federal Reserve, salivating at the prospect of higher disposable incomes, seem to disagree.

Let’s start with an important point: we need to abandon the notion that the world is now more productive as a result of collapsing oil prices. We have not, in a matter of weeks, figured out how to extract a barrel of oil with fewer men or machines. The productive potential of the US economy, for instance, is exactly what it was in early summer, before the crash in oil prices. What has occurred, instead, is a glut in oil, so producers, desperate to book a sale, are undercutting one another. In other words, there has been a transfer of wealth: income that previously flowed to oil producers is now flowing to oil consumers.

But while the supply side is unaffected, demand is certain to change. The propensity to save varies from one economic agent to another—a US consumer, for instance, might spend a higher proportion of their income than the Saudi government. Therefore when income shifts, so does the level of spending.

But how do we decide whether spending goes up or down? To help us understand, let’s imagine the unrealistic example in which America buys all its oil from domestic shale producers. This means that shale profits, which were previously ploughed back into new drilling, are now in the hands of consumers and non-oil corporations. In fact, the transfer is larger than just the profits, since shale producers also piled up a lot of debt to turbo-charge their drilling. And whereas the shale producers could be relied on to spend their income on new investment, these consumers and corporations are somewhat more reluctant to inject their new money back into the real economy. And they’re even more reluctant to juice that new income with multiples of debt.

In other words, for total spending in the US economy to stay constant, consumers and non-oil corporations must make up for all the reduced spending (both from profits and debt) of the shale producers.

And what do we know about the behaviour of consumers and corporations? Consumers, it is often said, save more of their income the richer they are. This is the reverse of the argument for redistribution — the poor spend a higher portion of their income than the rich. So as the real income of consumers rise, so does their propensity to save. We also know that corporations are accumulating massive hoards of cash on their balance sheets, increasing dividends and stock buybacks but not necessarily investing profits into new production. So in both the household and the corporate sector, a lot of the transfers from producers to consumers of oil may simply be saved, and the economy would suffer.

Of course, Americans don’t buy all their oil from US oilfields. Despite buoyant domestic production, the US is still a net importer of crude. So to complete our analysis, we need to figure out what foreign oil producers do with the US dollars they earn. How much do they save? How much do they spend on US exports? We need to know this data in order to understand what happens to total real spending in the US economy.

Ultimately, the question we need to answer is this: will US spending rise or fall if money that was once in the hands of foreign oil companies and US shale producers is now in the hands of consumers and non-oil corporations? Will Saudi Arabia dig into its sovereign wealth fund, thereby reducing or reversing the flow of savings it currently sends to the US? And if so, will the effect boost total spending? Or might the secondary effect of reduced foreign savings be a stock market crash that damages expectations? Will consumers, their animal spirits lifted by lower gas prices, actually reduce the portion of their income they save? Or will they do the exact opposite, seeing a gas price windfall as the perfect opportunity to further reduce debt?

I’ll leave the task of answering these questions to the brave analysts at investments banks and other organisations, because, quite frankly, it’s impossible to know for sure. We can point to past examples of how falls in oil prices might have boosted demand (in the Clinton years, for instance) but can we honestly extrapolate from this data today, when corporate cash balances are at record highs and shale producers are boosting investment demand? No two scenarios are ever the same, and we need to stop pretending that they are.

What’s clear though is this: in an environment of rock bottom interest rates, our bigger concern should be insufficient, not excessive, demand. An upward spiral in spending would be a godsend, and the central bank could always raise interest rates if the spending got out of control. But if the collapse in oil prices triggers a downward demand spiral, our central banks, with rates already at zero, would be helpless. This is why the recent collapse in oil prices should make central bankers more cautious, not less, about tightening monetary policy.


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