Recently (since December) we have seen US bond yields start to inch up and at the same time oil prices (and other commodity prices) have also inched up. This seem to be a great worry to some commentators – “Higher oil prices and higher bond yields will kill the fragile recovery” seem to be the credo of the day. This, however, reveals that many commentators – including some economists – have a hard time with basic demand-and-supply analysis. Said, in another way they seem to have a problem distinguishing between moving the supply curve and moving the demand curve along the supply curve.
Oil prices can increase for two reasons. First, oil prices can increase because there has been a drop in the supply of oil or expectations that that will happen in the future – for example due to war somewhere in the Middle East. Or second oil prices can increase because of increased global demand due to easier monetary conditions globally (an increase in global NGDP growth). The first effect is a move of the supply curve to the left. The second is move on the supply curve. This difference is extremely important when we talk about the impact on the global economy – first is bad news and the second is good news for the global economy.
What we need to know when we look at market action is to know why asset prices are moving and the best way to do that is to compare how different asset markets are moving.
As I have shown in my previous post higher long-term bond yields is an indication of higher future growth in nominal GDP. Therefore, if both oil prices and long term bond yields are inching upwards then it is probably a pretty good indication that monetary conditions are getting easier – and NGDP growth is expected to increase. To further confirm this is might be useful to look at equity prices – if global equity prices also are inching upward then I think one can safely say that that reflect a shift in the global AD curve to the right – hence global NGDP growth is expected to increase. This actually seem to be what have been happening since the ECB introduced the so-called 3-year LTRO in December.
On the other hand if oil prices continue to rise, but equity prices start to decline and bond yields inch down – then it is normally a pretty good indication that a negative supply shock just hit the global economy. That, however, does not seem to be the case right now.
I continue to find it odd that so many economists are not able to use the most useful tool in the the economist’s toolbox – the supply-and-demand diagram. It is really pretty simple. However, how often have we not heard that rising inflation will hurt the consumer and kill the recovery? This is really the same story. Inflation can increase because of higher nominal demand or because of lower supply. If demand is increasing – monetary conditions are becoming easier – then there really is no need to worry about the recovery. In fact we know that there is a close positive correlation between NGDP growth and RGDP growth in the short-run so any indication of higher NGDP growth in the present situation should really be expected to lead to higher RGDP growth.
So next time you hear somebody say that higher oil prices or higher bond yields might kill the recovery ask them to explain what they mean in a demand-and-supply diagram. If they move the supply curve to the left – then you need to ask them how they explain that global stock prices have been increasing as well…of course is stock prices indeed been falling then their analysis is of course correct…
PS needless to say we can of course have a situation where both the supply curve and the demand curve is moving at the same time. This often happens when central banks are unable to distinguishing between demand and supply shock. Hence, if inflation increase due to a negative supply shock as was the case in 2011 and then central banks react by tightening monetary conditions as the ECB did in 2011 then you get both the supply curve and the curve moving…(The ECB obviously made this policy mistake because somebody forgot to draw supply-and-demand diagrams…).
UPDATE: Our friend Jason Rave has a comment on a similar topic over at his blog Macro Matters. As me Jason is not worried about rising oil prices if they indeed do reflect higher global demand.