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.
jpirving
/ March 21, 2012I think that what has happened, is that economists have talked down to the media for so long (so as to get in the press more), that they started to believe their own oversimplified unmodels.
JP Koning
/ March 21, 2012“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. ”
How do you explain the “great moderation”? Generally rising equity prices through the 80 and 90s which, as you point out, may indicate an expected increase in global NGDP, and generally falling oil prices.
Lars Christensen
/ March 21, 2012Jpirving, I am afriad you are totally right. Many – especially financial sector econonmists like myself – tend to be intellectually lazy. It is often the “demand” to grap a headline or give a statement in 1 minute. The problem is that most journalists live in a very simplified Y=C+I+G+X-M world and then economists tend to play along with that. It is also a problem that most of today’s economic commentators “grew up” during the Great Moderation and hence do not really understand monetary matters.
Lars Christensen
/ March 21, 2012JPK,
That is an very intersting question. In my view the bull run in global stocks during the 1990s to a very large extent was a result of a shift in monetary policy. After Volcker defeated inflation NGDP growth became significantly more “forecastable”. This in my view caused a major drop in the risk premium in US equities. Have done some empirical works which strongly confirms this. However, global NGDP growth also slowed strongly and that caused commodity prices to drop. The story is perfectly consistent, but that is something I want to write more on in the coming weeks.
dwb
/ March 21, 2012there is a lot of research (e.g. Bernanke/Gertler, i recall) that the recessionary effect of high oil is through macro policy.
generically, high oil killing the recovery IMO is more a statement that the Fed will overreact to supply inflation and tighten, and less a supply demand story. i think that is certainly a possibility!!
Hamilton blogged about it a bit ago and had a more sanguine take on it (see below). Fortunately, that site is heavily trafficed by reporters, bloggers, and economists in and out of industry and his analysis/research is given a lot of weight.
http://www.econbrowser.com/archives/2012/03/oil_prices_and_3.html
Lars Christensen
/ March 21, 2012dwb, I totally agree – central banks have often erred by tightening monetary policy in response to negative supply shocks. I am not overly concerned about the response of the Fed to the present increase in oil prices (which I by the way think mostly is a result of easier monetary policy globally). However, I do worry that the ECB move prematurely to tighten monetary policy – as it was the case in 2008 and 2011.
Benjamin Cole
/ March 21, 2012The worst thing the Fed can do is fight global commodities inflation with US monetary policy. They may dent global commodities prices, but will suffocate the US economy in the process.
If you worship price stability—if you have a fetish for constancy in a subjective nominal index of prices—I suppose this is a fair trade-off.
I worship at the the altar of economic prosperity, so i hope the Fed ignores oil prices, and concentrates on economic growth.
Lars Christensen
/ March 21, 2012Benjamin, I wish you could become GOP presidential candidate. The US right needs somebody who actually is a voice of both reason and optimism!
Benjamin Cole
/ March 22, 2012Lars-
I never thought I would say this, but the bar is too low for GOP candidates. I can’t get under it. And mediocrity is my forte!