What's in a Price? Less Than You Think
Over the years, I have written a good deal about crude oil: crude oil prices, that is. I don’t presume to have any unique insights into the inner workings of OPEC or a comprehensive knowledge of hydraulic fracturing techniques. I do not have contacts at major energy producers. Nor do I have wildcatters checking in with their latest discoveries.
What I do have, apparently, is an understanding that a change in the price (P) of a stock, bond or commodity tells us nothing about the effect on the quantity (Q). “Never reason from a price change,” is how economist Scott Sumner, director of the program on monetary policy at George Mason University's Mercatus Center, encapsulates a concept that should be enshrined in every economics textbook. “Drawing inferences from price changes is not really justified,” Sumner says.
And often incorrect, he might have added. When oil prices declined 60 percent between June 2014 and March 2015, economists assumed the collapse was solely a result of increased oil supply. They declared it an unqualified plus for the U.S. economy and a "big tax cut" for the consumer, whose savings from filling the tank could be spent elsewhere. Federal Reserve policy makers expected lower oil prices to "boost household purchasing power." The net effect was "likely to be positive for economic activity and employment in the United States," according to the minutes from the March 17-18 meeting.
Let's see how that's worked out. Investment in mining exploration, shafts and wells plummeted an annualized 49 percent in the first-quarter. Retail sales and industrial production have hit the skids. The first look at first-quarter real GDP growth was dismal: an increase of 0.2 percent. The second look, due on May 29, should show an outright contraction, based on subsequent data releases and revisions. The Atlanta Fed's second-quarter GDPNow forecast is 0.7 percent. (The Atlanta Fed downplays the reliability of its estimate until more second-quarter data become available.)
As for employment, the Bureau of Labor Statistics reported a 6,800 decline in oil and gas extraction jobs since the recent high in December 2014. Companies that support oil and gas operations have cut 21,000 jobs since the September peak. Throw in oil-related manufacturing industries, such as steel, and by some estimates 100,000 jobs may have been eliminated as a result of lower oil prices.
This is hardly the first time economists have ignored Sumner's mantra. In early 1986, the Saudis opened the spigots, sending oil prices tumbling to $10 a barrel in April from $35 in November 1985. The Fed was easing aggressively. The hype was pretty much the same as now: a big tax cut for consumers, unqualified good news for the U.S. economy. As it turned out, real GDP expanded 1.8 percent in the second quarter of 1986. Ex-post, economists discovered the devastating effect of lower prices on oil-producing states.
If economists can't differentiate between price changes coming from the supply side versus the demand side when it comes to oil prices—often the source is impossible to ascertain in real time —imagine their confusion when it comes to interest rates. Sumner, who blogs at The Money Illusion and EconLog, takes many noted economists to task for reasoning from a price change. Nobel laureate Robert Schiller is guilty of viewing low real interest rates as an incentive for investment. (Not if those low rates are the result of reduced credit demand.) Larry Summers is guilty of equating low interest rates with easy monetary policy. (They can be a reflection of easy policy or a response to overly tight policy.) Paul Krugman, another Nobel Laureate, is guilty of (among other things) assuming higher interest rates lead to lower inflation, again failing to differentiate between cause and effect.
The Fed is equally confused when it comes to long-term rates. If you were to ask policy makers if interest rates move pro-cyclically, they would all answer yes. But when rising market rates become a reality, the cries go out that higher rates will damage the economic growth. At the same time, a decline in long rates is automatically assumed to provide economic stimulus. Alas, the expectation that the 100-basis-point decline in 10-year Treasury yields last year would boost investment was mugged by reality.
Getting back to oil prices, economists are still waiting (hoping?) for the oil-price-tax-cut to materialize. Bad weather is getting old as an excuse. More likely, the 60 percent June-to-January decline in U.S. benchmark crude prices was the result of a multi-year increase in global output, as technical innovation reduced the cost of extracting oil from shale, combined with a sudden cutback in global demand. The dive in prices coincided with negative economic news from Europe and slowing growth in emerging markets, including China. If supply and demand were in balance as recently as last June when oil prices were $100 a barrel, it is hard to explain the sharp, sudden price decline as a supply phenomenon.
If, on the other hand, prices fell because consumers were demanding less energy-related products at any given price than they did before, then lower prices are a result, not a cause of stronger demand in the future.
Of course, as a journalist this topic has proved to be extremely fruitful over the years. What other subject would provide an opportunity to write thousands of words when a single picture would suffice?