Can oil prices possibly go higher? Everyday, we get the same answer, as one shocking number replaces another. However, here is a more interesting question - how high do oil prices have to rise before central banks act?
Central banks may not have any oil rigs in their backyard, but they are responsible for the price of oil. Since last August, the large central banks have either cut rates (the Fed, the Bank of England) or maintained very low rates (the ECB) at a time when inflation has picked up. As central banks have delayed responding to the growing inflationary threat, price expectations have picked up. Nowhere is this more true than in the oil market.
Lower rates reduced storage costs for oil. It was already a tight market before the monetary easing. With little prospect that demand will slide in the short run, it pays to be holding onto oil right now.
Lower rates has also prompted a speculative frenzy. The rate of return on riskless short term treasury bills are negative. Rather than lose purchasing power, many investors have turned to the one market making serious money - commodities, and in particular oil.
Today's commodity markets are deeply mired in a speculative bubble. Like all bubbles, prices rise because they rise. This may have a circular logic, but over short time horizons, it has sufficient plausibility to push the oil price up to $142 or higher. In the absence of a better reason, oil keeps going up, and as it does, it encourages investors to take a punt on an even higher future price. Anyone looking for a high risk, high return investment today buys an oil futures contract.
However, it is hard not to be struck by the irony behind today's oil price rise. Back in 2001, central banks tricked their way out of a modest slowdown by cutting rates. That spurned the housing bubble. For a while, central banks seemed to get it right; rapid growth, low inflation, and appreciating asset values.
Then housing went bad and threatened to take down the banking system. The Fed and the Bank of England tried the same old trick - lower rates. Only this time, it generated a nightmare - a commodity price bubble. Now central banks are trapped; the banks are still in trouble, inflation is rising out of control, and economic growth is slowing rapidly.
So what is the way out of this mess? The first step to recovery is to recognition - central banks must understand the magnitude of the problem and the dangers of inaction. The second step is prioritize; the key problem is inflation. If prices are stable, economies will recover quickly. Bank failures are nasty, but if they are cleaned up quickly, financial systems can recover. Inflation, on the other hand, can take decades to control. Sort out the inflation problem first, then move onto the banking problem with a slash and burn strategy. The economy will take care of itself.
Only central bankers can stop this frenzy in the oil market. If the Fed raised rates today by 100bps, the price of oil would be $80 by Monday morning. It is that simple.