Oil, the Dollar, and Inflation

Oil prices have been rising for some time but have soared since the political unrest in the middle-east flared up earlier this year.  Increases in the price of gas show no signs of stopping as oil refineries switch from winter blends to summer blends and the summer driving season nears.  Talk of $5.00 a gallon for gas that seemed so unrealistic last year now seems possible.  Reported inflation rates may not include energy but should these prices remain or get worse, it would seem that Americans would be forced to change their consumption patterns just to afford the gas to get to the necessary places in life like work and school.  Oil impacts almost every part of our life when you consider the products that we use, the added shipping costs, and the added production costs on virtually everything we buy or use.  Food costs are increasing due in no small part to the rise in energy prices. 

It is interesting to note that from 1974 to 1984 the dollar was more reactionary to what was happening in the gold and oil markets.  In other words, gold and oil were leading indicators of what would happen to the dollar.  This was a period of great volatility due to oil shocks, stagflation, and political unrest both at home and internationally.  From 1984 to 1997 the three seemed to move in tandem during a period of strong economic growth and relative worldwide peace.  The period from 1997 through today indicates a divergence between all three measures.  Gold has increased in value almost non-stop, while oil and the dollar have generally moved in tandem albeit in opposite directions.

Since 2005 the interaction between the three is even more evident.  Oil and the dollar have move in almost perfect divergence from one another while gold has continued on its path higher albeit with a few bumps in the road.   

So, what can we take from this?  First, the political and fiscal uncertainty over the last fifteen years or so has led to the rise in gold prices as investors seek a safe haven.  Next, there is a significant relationship between oil and the dollar.  As one move’s higher, the other falls and because the dollar is on a downward trek over the last year, it is easy to see why oil has gone up so much.  In fact, ever since the Fed announced QE2 last year, the dollar has been falling and oil rising.  As we talked about last month, however, QE2 is supposed to end by June 30th (according to recent Fed announcements, it will end by then) and that may allow the dollar to move higher.  Should this happen, and should the dollar’s relationship with oil hold, we should see oil prices decline.  It certainly will make for an interesting summer.

Oil and inflation seem to have a clear relationship as well.  While it hasn’t always held true, the price of oil seems to preview what will happen with inflation.  Think of the oil shocks in the 1970’s and the inflation that came about at the end of the 70’s and the early 1980’s.  The 1990’s was a time of generally falling oil prices and inflation was pretty tame then too.  So far in this century we have had high and low oil prices but we have generally not had higher inflation.  While lower inflation is good, the unfortunate side to it so far in the 2000’s is that we have had too many periods of weak economic growth. Oil has stayed low because of the weak growth and inflation has to although the economy seems to have been the driver not oil itself.  Lately, however oil has soared again and the inflation seems to be tagging along. 

What do you think?  Will the high price of oil impact your budget?  How about your vacation and driving plans?  Gas in Madison seems to be hovering around $4.00 a gallon – ouch!

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