Caroline Baum of Bloomberg does a good job explaining that high oil prices are neither necessarily indicative of inflation, nor necessarily cause inflation.  If oil prices increase because of a supply disruption, this is precisely what should be expected:

Higher oil prices don’t cause inflation. They aren’t synonymous with inflation. Higher oil prices represent a relative price increase until proven differently.

Indeed.  And the trick when looking at oil prices, or really any commodity price, is to tease out which part of the change might be attributable to supply and demand considerations, and which might be due to monetary hijinks. 

If a commodity is increasing in price when most others aren’t, the chances are great that cause of the increase is fundamental to the underlying supply and demand metrics for that commodity.  Likewise, if all commodities increase in price, the chances are great that supply and demand fundamentals are not driving the increase.  If supply and demand fundamentals aren’t driving the increase, then the first place in explaining prices is to look at the money with which prices are communicated. 

Oil has lately breached $100/barrel, purportedly on the basis of supply disruptions due to unrest in the Middle East.  But then, why had oil nearly tripled in price over the span of about two years prior to the 12% or so increase after the Egyptian revolt?  Why have all commodities been lately careening higher in price?  Are supply disruptions suddenly endemic in all corners of the globe’s producers in all of the various commodities?  Contrary to Paul Krugman’s claim that global warming is crimping agricultural supply and driving prices higher, there has been no real decline in overall global output of the foods, particularly grains, that are so critical to human survival.  Nice try, Paul, but, as you so often do, you let your lizard political brain control your economic reasoning. 

When all prices of all commodities increase more or less simultaneously, it has to be the money.  The money has lost value relative to the goods and services it is intended to represent.  This decrease in the value of money is dubbed inflation, because it is revealed by an increase in the amount of money (prices) paid to acquire goods and services. 

But people will refuse to believe that inflation is causing increased prices until it becomes so obvious until the conclusion is unavoidable.  The news headlines are already cranking out daily explaining that, e.g., that coffee beans are getting more expensive because of bad weather in Columbia, though Columbia is hardly the only producer of coffee beans; that orange juice is getting more expensive because of the cold December in Florida, even though the crop was hardly affected; that oil is getting more expensive because of Gadhafi in Libya, even though oil coffers are about now brimming full all across the world, and there is plenty of excess capacity to make up for any Libyan shortfall; or that wheat prices are peaking because of poor harvests in Russia last fall and in China this winter, even though aggregate harvests worldwide are down only a trifle from their all-time record in 2009. 

If supply disruptions aren’t blamed for the price increases, they will be blamed on demand growth in developing countries, particularly China.  It is true that demand for commodities, particularly minerals and metals, has grown since late 2008/early 2009, when worldwide economic activity plunged and slowed substantially the process of industrialization in the developing world.  But economic activity has yet to reach its pre-crisis high, while prices have doubled and tripled in some cases. 

Some part of the commodities price increases seen over the last two years could certainly be attributable to resurgent economic activity expanding demand across the board.  But some portion of demand expansion is the result of price increases.  When prices are accelerating upward, demand expands because future purchases are brought into the present.  Hoarding becomes a strategy of making money (or at least minimizing losses) in the face of increasing prices, which in turn yields expanded demand, which very well may prompt some considerations of supply shortages (particularly in agricultural commodities), which further increases prices, which makes hoarding more attractive, etc.  It is known that China has huge stockpiles of grains–rice, wheat, corn, etc.  What is not clear is whether China’s accelerating appetite for everything from industrial metals to precious metals to oil is driven by the underlying demand fundamentals in her economy or by China’s compulsion for hoarding.

There may very well be a serious supply disruption that causes oil prices to double, or even triple from here.  It would take a catastrophe of epic proportions, but oil has a delicate and technologically-sophisticated supply chain susceptible more than most commodities to the vagaries of human or natural catastrophes.  It hasn’t happened yet, but may still.   Personally, I hope for it, so the US might finally realize the folly of basing so much of our economic fortunes on an international oil market dependent on inherently unstable political regimes.

In the meantime, oil prices aren’t screaming higher along with virtually all other commodities because of supply and demand metrics.  They are doing so because of the US Federal Reserve.

Advertisements