Posted by: Dirk | February 29, 2008

Hedging inflation risks by buying oil: a vicious circle?

A vicious circle might arise from the constellation that is described in today’s FT:

The emphasis on growth rather than inflation by the chairman of the US Federal Reserve prompted investors to seek refuge in real assets such as gold and crude oil as a hedge against future inflation.

Let’s go through this step by step. We start with fears of higher future inflation of the dollar (rising prices in the US). Investors react by investing in oil. This drives up the oil price. Higher oil prices are bad for the US economy. The Fed reacts to this by lowering the interest rate some more. This means that money supply is expanded, which creates higher inflation. If this influences expectations of future inflation, then more investors will want to hedge against this future inflation. We are back at the start.

What are the possible outcomes? One possibility is that the Fed at some point cannot lower interest rates anymore (nominal interest rate is at zero). The higher oil prices will then suffocate US industries, a major contraction would possibly follow. But there might be a way out: as the vicious circle unfolds, the dollar devaluates some more. This opens up opportunities to increase exports and switch expenditure from imports to US goods. It seems unlikely though that this will rescue the US economy. These things need months to take effect, whereas financial markets are quick.

By the way: a major US recession will cause the oil price to come down. Anyone who hedged against future inflation will be disappointed: you get higher inflation (until the US economy stalls) plus a lower oil price! How can the vicious circle be broken? Increase oil supply. This is highly unlikely, since that would take years. Then, stop the possibility of speculationg with oil. This can be done. Maybe it should be considered.

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