Examining the Fed’s policy and its potential effect on oil prices

On Friday, February 4th, Federal Reserve Chairman – Ben Bernanke gave a speech on the monetary policy of the Federal Reserve for the near future.

He said that the Fed will continue with its plan to purchase treasury worth of 600$ billion, i.e. quantitative easing 2. According to the chairman, this monetary policy easing will help reduce the short and, consequentially, long term interest rates and ease the financial condition, so that commercial banks will have a broader base for lending.

During a period of over a year, from 12/2008 to 3/2010, the Fed purchased nearly 1.7$ trillion long term treasury, agency and mortgage-backed securities. As a result, there are indications, which Bernanke also refers to in his speech, showing a rise in US inflation rate.

This includes, among other, the recent rise in long term U.S. government yield; e.g. since September 2010 until February 2011 the average 10 year yield of U.S. government bond rose from 2.52% to 3.64%, a 1.12 percent points rise. The reasons for this rise could also be due to the increase in risk premium of US government bonds and inflation pressures.

The main problem that could arise from the monetary easing is the decline in the worth of US dollar compare to major other currencies and to major commodities, and thus the US inflation rate will start to pick up in the US.

Since the Fed is also purchasing government bond, by doing so, this is an indirect “inflation tax” or better known as “government printing money”: the government prints cash to finance its activity, and since the Fed is printing US dollar and purchases with it US bonds.

The process is very similar to “inflation tax” with one exception, at the end of the period, the government supposes to payback these funds to the Fed, and you know how they will resolve it in 10 years – raising taxes.

Chairman Bernanke also referred to the notion of “core inflation” in which he only looks at the US inflation rate sans energy and food commodities’ prices that are too volatile. According to this analysis the current inflation is only 0.7% during 2010 compare to the 1.2% for the “full inflation indicator” in 2010.

This analysis of excluding food and energy, which are major components of household purchases could be misleading: even though these commodities’ prices are very volatile, their upward trend in recent year is not something to dismiss and could strongly be related to the decline in US economy and the recent monetary policy easing.

Let’s breakdown how this recent news could affect the commodities markets in particular the demand for crude oil:


Crude oil market

There two main forces working here worth mentioning:

Crude oil is considered an investment to fall back on when the US dollar value is devaluated. The current monetary policy could affect the US dollar to decline in value compare to major commodities and thus it could cause a rise in demand for crude oil as an alternative investment, along with upward pressures in crude oil price.

There is also the demand for oil: if the monetary policy will work out as expected by the Fed, it will improve the condition of the U.S. economy which will stimulate more businesses and consequentially the demand for energy will likely to rise; as a result, there will be pressure for crude oil price to increase.

Therefore, it seems that in both cases the Fed’s monetary policy could further cause to crude oil price to rise. Since, however, there are many other factors that affect crude oil price, it’s premature to speculate that energy prices will increase in 2011 based on the Fed’s policy.

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