The price of crude oil has plunged in recent weeks, and there is both concern and rejoicing over the drop. The rejoicing comes from consumers as well as many retailers who hope that the increased cash in the hands of families will increase spending at the mall. The concern comes from business and some government officials, who worry that the drop will exacerbate concerns for deflation. Some are debating whether the drop in oil prices is due to supply forces or demand forces.
Prices are determined by the countervailing forces of supply and demand, but movements as large as recent movement of oil prices seem to be difficult to attribute to a change in demand or supply. A couple of things should be kept in mind. First, there has been a huge increase in supply, especially from increased production in the U.S. The increase is due to technological change involving fracking and other techniques that have enabled companies to produce oil from sources they could not in the past. On the demand side, the world economy is still sputtering, and China's growth rate has fallen. But both of these forces have been in place for awhile, which would suggest a more gradual decrease in prices than we have observed. This brings me to the importance of expectations. Prices reflect both today's realities as well as expectations about the future. Expectations can change rapidly, and probably have in this case.
Expectations affect both sides of the market. On the supply side, some OPEC members (primarily Saudi Arabia), seem convinced that the increased supply in the U.S. is not a fluke. But, they also know that the costs of extracting oil are higher in the U.S. than in the Middle East. Processes that are profitable at $80 a barrel may not be at $40. U.S. producers will not change production immediately because it is costly to do so and because oil prices can rise quickly too. Saudi Arabia has stated that they are willing to maintain production even if oil prices fall further. I presume they are taking the long view and hoping that over time the growth of U.S. production will slow down or reverse. Given the large number of producers now who are not part of OPEC, they may be overestimating their influence on oil markets today. On the demand side, expectations may be that there will not be a big increase in demand for awhile since Europe seems to be stagnating and China could not keep growing at double digit rates.
Finally, what about the concern for deflation. According to Milton Friedman--inflation (or deflation) is always a monetary phenomenon. Changes in oil prices are relative price changes and do not cause all prices to change in the same direction. However, oil is an extremely important input into almost all goods since goods have to be transported. Further, it is likely that central banks no longer have as much control over the money supply as they used to have due to technological changes in banking and more open economies. Still, if the Fed does nothing in response to the oil price changes, the reduced prices for oil should generate increased in demand for some other goods as disposable income increases. It is a change in relative prices, after all. However, oil prices have more impact on policymakers than prices of most goods. So, the Fed is likely to feel they must react in some way because they are concerned about deflation. The experience from the 1970s and rising oil prices was that the Fed accommodated higher oil prices by increasing the supply of money and generating more widespread inflation. Hopefully, some lessons were leaned from the 1970s and Fed reaction can be more muted today.