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There are many factors behind the sharp increase in the oil price, but one is usually overlooked: it's a bubble. Where bubbles appear in the market (think of housing and tech stocks, to name two in recent memory), you will find the hidden hand of monetary policy at work. This is an underlying issue that helps explain the price. Recognizing this also helps us make a better judgment concerning the future of the oil price as it relates to overall economic well-being.

According to the Fed's minutes of its April 29–30 monetary policy meeting, US central bank policy makers have turned more pessimistic on the growth of the economy. The Fed is now forecasting that economic growth is likely to hover between 0.3% and 1.2% in 2008 — down from the 1.3% to 2% range, which was the Fed's previous forecast.

The main reason for the lowering of the forecast is a sharp increase in commodity prices and in particular the price of oil, which Fed officials fear could ignite inflation expectations and lift the underlying rate of inflation. On Friday, May 23, the price of oil closed at around $132/barrel. The yearly rate of growth of the price of oil jumped to 106.3% from 72.9% in April. According to the University of Michigan's consumer survey inflation expectations one year ahead jumped to 5.2% in May from 4.8% in April and 3.3% in May last year.

It is usually assumed that rising inflation undermines consumer's real disposable income, which in turn weakens consumer spending. Since spending is the major component of real GDP, real economic growth is obviously going to come under pressure, so it is held. By this logic, if the price of oil were to continue to climb further, then at no time would Fed officials be forced to lower their forecast to negative growth.

Fed officials follow the Keynesian framework of thinking. In this framework, spending by one individual creates income for another individual. Hence the more people spend, the more income is generated. (What causes economic growth is consumer spending, so it is held.) Also, note that the source of a possible recession in this way of thinking is various shocks, such as an oil-price shock, that disrupts consumers' ability to spend.

Most commentators are of the view that the presently observed sharp increases in the price of oil are on account of supply problems. Existing oil fields are becoming depleted as time goes by while not enough new oil fields are being discovered. Some other commentators blame the supply issue on US government restrictions on extracting oil from various areas in the United States for environmental reasons. Without diminishing the importance of the supply factors, we suggest that another factor that must be considered is the contribution of the US central bank's policies to the recent sharp increases in the price of oil.

Fed Policies and Market Bubbles

What makes it possible to generate the goods and services that people require to support their lives and well-being is the capital infrastructure of the economy and not spending by consumers as popular economics suggests. It is the enhancement and the expansion of the infrastructure that permits an increase in the production of goods and services.

An improvement in the infrastructure makes economic growth possible. The key factor that enables the improvement of the infrastructure is the flow of real savings that funds the enhancement of the infrastructure, i.e., enables the production of various tools and machinery also called capital goods. (With better tools and machinery, a better quality and a greater quantity of goods and services can be now produced.)

In a free unhampered market economy, the established infrastructure is in accordance with the tendency towards the harmony between various activities. On this Murray Rothbard, paraphrasing Ludwig Lachmann, wrote,

Capital is an intricate, delicate, interweaving structure of capital goods. All of the delicate strands of this structure have to fit, and fit precisely, or else malinvestment occurs. The free market is almost an automatic mechanism for such fitting; … the free market, with its price system and profit-and-loss criteria, adjusts the output and variety of the different strands of production, preventing any one from getting long out of alignment.

This harmony gets disrupted by the monetary policies of the central bank. An artificial lowering of interest rates by the Fed and the subsequent increase in the rate of growth of money supply gives rise to various nonproductive activities — bubble activities.

We define a bubble as the outcome of activities that have emerged on the back of the loose monetary policy of the central bank. In the absence of monetary pumping, these activities would not have emerged.

As a result, the economy's infrastructure gets distorted. Various projects are undertaken that, prior to the artificial lowering of interest rates and increased monetary pumping, would not be considered.

The increase in money supply, which supports various new projects, sets the foundation for additional demand for various commodities, including oil. More money is channeled toward commodities and oil. Since the price of a good is the amount of money paid per unit of the good, this means that the prices of commodities and oil are now going up.

Once the central bank tightens its monetary stance, the diminished flow of money weakens the expansion in the bubble activities — an economic bust is emerging.

Observe that bubble activities are supported by means of loose monetary policy, which diverts real funding to them from wealth-generating activities. Once the money rate of growth slows down, this slows the diversion of real wealth, i.e., slows down the support for nonproductive activities. As a result, the demand for various goods and services that emerged on the back of nonproductive activities comes under downward pressure. Consequently, the prices of these goods, such as various commodities and oil, follow suit.

Following this line of thinking, we can suggest that there is a high likelihood that the massive increase in the price of oil that we are currently observing is the manifestation of a severe misallocation of resources — a large increase in nonproductive activities. It is these activities that have laid the foundation for the oil-market bubble, which has become manifest in the explosive increase in the price of oil.

The root of the problem here is the Fed's very loose monetary policy between January 2001 and June 2004. The federal funds rate target was lowered from 6.5% to 1%, while the money rate of growth had risen strongly. Between Q3 2001 to Q4 2004, the average yearly rate of growth of our monetary measure, TMS, stood at 7.5%. This should be contrasted with the rate of growth of 2% in Q2 2001 and 0.8% in Q4 2000. The easy monetary stance has given rise to various malinvestments, which we have labeled here as bubble activities.

From June 2004 to September 2007, the Fed had been pursuing a tighter monetary policy. The federal funds rate target was raised from 1% to 5.25%. In response to this, the yearly rate of growth of our monetary measure TMS fell from 7.1% in Q4 2004 to 0.4% in Q1 this year. Because of this sharp fall in the growth momentum of money supply, various nonproductive activities are currently coming under pressure. This in turn should start hurting the prices of various commodities, including oil.

Regrettably, the loose monetary stance that the Fed has adopted since September of last year (the federal funds rate was lowered from 5.25% to 2%), after a time lag, is likely to arrest the removal of various bubble activities and lay the foundation for the increased presence of these activities.

Obviously if the pool of real savings is shrinking — i.e., the flow of real savings is no longer sufficient to support various existing and new activities — economic growth will come to a halt and commodity prices will come under downward pressure, notwithstanding the Fed's aggressive lowering of interest rates since September of last year.

Now, it is not only the Fed's policies that must be blamed for sharp increases in the price of oil but also the policies of other countries such as China. Massive monetary pumping in China and the various structures that emerged on the back of monetary pumping there have contributed to the exaggerated increase in demand for various commodities, including oil.

For the time being, the pace of China's nominal economic activity continues to push ahead. We have estimated that the yearly rate of growth of nominal economic activity stood at 38% in Q1 against 36% in the previous quarter. This, coupled with an upcoming effect of the loose Fed's stance since September 2007, is likely to mitigate the downward pressure on the price of oil, all other things being equal.

Conclusion

We suggest that there is a high likelihood that the massive increase in the price of oil is the manifestation of a severe misallocation of resources. The loose monetary policy of the Fed from January 2001 to June 2004 is the likely key factor behind this misallocation. (The federal funds rate was lowered from 6% to 1%.) The tighter Fed stance from June 2004 to September 2007 should undermine the existence of various nonproductive activities and in turn reduce upward pressures on the price of oil.

Regrettably, the loose monetary stance that the Fed has adopted since September of last year, coupled with still very buoyant Chinese economic activity, is likely to counter any downward pressure on the price of oil. The Fed's current policy of fighting an emerging economic slump is, in fact, a policy of deepening the misallocation of resources, thereby promoting higher prices for oil. If our thesis regarding the oil market bubble is valid, then it is the Fed's policies that must be blamed for the erosion in consumers' living standards and not the rising price of oil.