Oil Soars, Dow Rises, Trouble Ahead

Economists like to believe that markets are driven by supply and demand. Traders know that markets are driven by greed and fear. The latter viewpoint explains why Tuesday saw oil hit a new record price while the Dow Jones Industrial Average put in a 195-point gain on expectations that the Federal Reserve is ending its interest rate hikes. Greed beat out fear, and the whole thing was irrational. Trouble arises out of such market perceptions.

Rising oil prices are bad even for the producers of crude oil after a certain level is reached. For oil consumers, price increases act like a tax on the economy. Oil is the necessary resource for running a modern economy, and when it gets more expensive, everything costs more. That is whence the inflation bomb of the 1970s came. Producers wind up with wads of cash they can’t readily absorb into their own economies while consumers are encouraged to reduce demand in the long-term. Some analysts believe that the sooner oil gets to $100 a barrel, the faster the US and others will develop alternatives, permanently altering demand and ultimately bringing back $20 a barrel oil. That is bad for the producers in the long run.

At the same time, the Fed may actually have finished its interest rate hikes, or it’s getting close. This is always good for stocks and general investment. The price of borrowing always affects the amount of borrowing for investment that happens. However, if the Fed is done raising interest rates, then that also means that there is less reason for international business and foreign governments to buy US dollars. Capital flows determine foreign exchange rates in the long term, and interest rate differentials affect capital flows in a most fundamental way.

A falling dollar, of course, helps certain groups, most notably US exporters. Other groups, importers and those whose commodities (like oil) are priced in US currency, take a hit. Theoretically, a falling dollar should boost US exports, reduce imports into the US and, thereby, help reduce the trade deficit. However, it is also possible that the commodities the US needs to run its economy will rise in dollar terms to offset the losses commodity producers suffer on their foreign exchange. That will slow down the US economy.

If the US economy does slowdown, interest rate cuts and deficit spending will be required, which will both drive the dollar lower. This is how markets overshoot equilibrium levels, fixing one problem by exaggerating another. None of this has to happen, naturally; economics is an art rather than a science, no matter what they may say at the University of Chicago. However, the US has ignored its economic problems for too long, and chickens do come home to roost. That is the message of record oil prices and a simultaneously rising stock market -- a dismal “science” indeed.

© Copyright 2006 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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