The Fed Does Not Pump Up Oil Prices

 | Feb 26, 2013 | 5:00 PM EST
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I cannot tell you how many times I have heard people say, "The Fed is printing money and that's why oil prices are rising." The only thing that determines the price of oil is supply-and-demand, and a big part of that supply/demand equation is the monopolistic factor in the oil market. By that, I mainly mean, the Saudis, who are really the only ones with any excess capacity. They set the price at the margin. The way they operate is to set the price to their customers and allow quantity to adjust. Same way the Fed sets overnight rates. They state a target rate, then manipulate reserves so that the rate is hit and held constant. Actually, it's even easier these days because they just pay interest on reserves, but I digress.

Getting back to oil, when it comes to the price, outside of the Saudis and supply and demand, nothing else really matters that much. Not the Fed's monetary operations or the size of its balance sheet or the foreign exchange value of the dollar. It's funny how people use the dollar's exchange rate as an argument to explain every fluctuation (mainly the up fluctuations) in the price of oil. They'll say, the dollar's falling, so that's why oil prices are rising. But how does the foreign exchange value of the dollar affect the supply and demand of oil? It doesn't. If the dollar falls, relative to, say, the euro, then a European gains purchasing power in exact proportion to the purchasing power lost by an American. The quantity of oil demanded has not changed and the amount of oil produced has not changed. The only thing that has changed is that now a European can buy a little more and an American can buy a little less.

On the belief that the Fed's monetary operations or, more specifically, monetary operations that result in an expansion of its balance sheet such as quantitative easing (QA) (some people call this "money printing") lead to higher oil prices, that's also not true. When the Fed conducts QE it buys government securities (bonds, notes, etc.) from the public and the banking system's reserves expand. The net financial position of the public has not changed. It still has the same amount of dollars, only in a different form—less dollar denominated bonds, more cash (reserves). And those reserves either just sit there in the banking system earning interest or they're ploughed right back into the purchase of more bonds again. There are no, "net new dollars" created. So how does that result in higher oil prices? It doesn't.

The red line on the chart above shows that oil prices rose from about $40 per barrel in 2005 to nearly $150 in 2008 -- even as the Fed's balance sheet (the blue line on the chart) remained relatively steady at about $800 billion. Then when the Fed really started to expand its balance sheet following the collapse of Lehman Brothers, oil prices got crushed. In a very short period of time, the Fed boosted its balance sheet from $800 billion to nearly $2.4 trillion and oil dropped from $150 to $35. Where is the correlation? The Fed was doing all this unprecedented "money printing" and oil prices were collapsing.

Since then, oil prices have recovered a bit; however, the Fed's balance sheet has kept right on growing and now stands at over $3 trillion. But oil prices have not made new highs. In fact, they're still under $100. When you look at the facts, there is just no truth to the claim that the Fed is causing oil prices to rise. Some traders may hop on this belief every time the Fed makes a change in monetary policy, and that may goose oil prices for a short period of time. But these moves ultimately reverse because there is nothing fundamentally supporting them.

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