Thursday, 23 March 2017

OPEC Vs Central Banks: The Battle of Global Inflation and Deflation

 For Every OPEC Action, There's a Central Bank Reaction 

The U.S. economy and equity market was cruising along in 2014. The global economies weren't strong then, but they were still hanging on the cliff by their fingers. They were slowly crawling up to the cliff to safety. Along came OPEC, who decided to push the price of crude oil down a precipice and taking global economies along with it. The reason? To kill the U.S. oil frackers and regain market share. And they were successful.

Weekly WTI prices from 2014 to 2017
Weekly WTI prices from 2014 to 2017

By 2015, both the the world economies and S&P 500 also started to lose their finger grips on the cliff. When crude price dropped from $110 in 2014 to $60 in early 2015, it was still okay for global economies and equity market. In fact, lower crude price is good for the economy. But if crude oil is continued to move below $60, world economies faced a problem that had been plaguing them since the Great Recession of 2008: deflation. So you can have too much of a good thing.

Cast your mind back to the 1970s, it was OPEC who created the rampant inflation that rattled world's economies. Like them or hate them, OPEC pulls the lever on global inflation and deflation via the oil prices. Of course, it's not their intention or interest to change global inflation landscape (however, it's their intention to exercise the immense power that they have in getting what they want). Because energy cost is such an integral part of the modern economies that crude oil prices are part and parcel of inflation calculus. So when crude prices spiked like those in the 1970s, 1990 or 2005 to 2007 period, inflation ticked up. And when crude prices dived like those in 1986, 2008, or the 2014 - 2015 periods, inflation declined.

Crude oil price from 1960 to 2017
Crude oil price from 1960 to 2017.


So it's up to central banks around the world to fight OPEC induced inflation or deflation by pulling their levers of official interest rates as the OPEC turning their oil field's sprockets.

So next time when you blame central banks around the world for money printing, you should spare a thought that they're simply reacting to OPEC's inflationary or deflationary pressure.

If you look at the 2 charts above (crude price and CPI charts, which measures inflation), every peak in the crude price chart (1970s, 1999 or 2005 to 2007) corresponds to a spike in CPI figures (years in black), and every trough in the crude price chart (1986, 2008 or 2014 to 2015) corresponds to a low bar in CPI chart (years in red).

During these periods of outlier inflation or deflation, central bank like the Fed would need to counteract these forces accordingly. Just look at how similar the charts of US CPI above and the US Fed Fund Rate below.

US Fed Fund Rate from 1960 to 2017
So the chain of events are clear. OPEC move prices up or down, this transmits to higher or lower CPI, meaning inflation or deflation, and the Fed (and global central banks) increase or decrease official interest rates accordingly. In other words, OPEC creates storm and wreaks havoc, and the central bankers would need to clean up the mess afterwards.

While crude oil isn't the only driver of inflation or deflation, but it's the singular most dominant force. I shouldn't sound like that OPEC is the only boogieman. It all gets to the economic basics of supply and demand at the end of the day. But OPEC, collectively as an oil cartel could exert more influence on oil price than any individual group (at least for now. But their influence is declining. This will be the topic for my next article). US oil frackers would soon give OPEC a run for their money.

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