Oil Prices an Economic Linchpin

Macro Perspectives: Thu 09 Dec 21

Continuing on from my previous note, where I compared the current period to 2014; domestic and geopolitical noise was high, and the Fed was ending its QE response to the financial crisis - and setting the table for the rate liftoff.

There was an additional important event in 2014: the Thanksgiving evening oil market surprise (discussed in the context of the shale industry in my previous notes. This is when OPEC pulled the rug on oil prices, with a well-timed announcement that they would not defend the price of oil with a production cut. This event turned out to play a very key role in the Fed's ability to follow through, in the coming years, with its rate "normalisation" plan.

What started as a slide in oil prices back in 2014, turned into a crash with OPEC's influence. Over the next year, as you can see in the chart below, oil traded down from over $100 to below $40 - ultimately bottoming out at $26 in 2016.

Oil prices are important.

Though the Fed always likes us to believe that their assessment of inflation excludes oil prices (which they argue are too "volatile" to consider), they have a very clear history of acting when oil prices make a dramatic move (higher or lower).

In this 2014 analogue, the Fed went from tapering and ending QE in 2014, to telegraphing and executing its first rate hike in nine years (in December of 2015). From there, they were telegraphing four additional rate hikes in 2016.

Oil however kept collapsing. A month into 2016, oil had fallen another 35% to the high $20s. That sounds great for consumers (cheap gas), but it also came with mass bankruptcies in the U.S. shale industry, and therefore threats to the creditors of the industry. It came with heavy deflationary pressures in the economy. Stocks melted down, having the worst start to a New Year on record.

With that, just one month after the Fed pulled the trigger on its first rate hike, they had to take the four rate hikes that they were projecting for 2016, off of the table - they were back on the defensive.

I revisit this scenario: 1) for the similarities between the current period and 2014 (excluding oil prices), and 2) to acknowledge a (low probability) scenario where oil prices could crash (under manipulation) and completely reverse the outlook on inflation, Fed policy and the economy. It's far from the high probability scenario, at this stage, but it's possible.

Oil prices are always an economic linchpin.