Wednesday, August 6, 2008

The fall in oil prices

In recent days, the price of oil has fallen to USD120 per barrel. The Economist op-ed piece made the observation that, Those looking on the bright side will also hope that a fall in the oil price will untie the hands of central bankers, allowing them to postpone the rate rises they may be contemplating to fight inflation.

At first blush, this seems to validate Bank Negara's decision not to raise interest rates. But that op-ed piece also makes the crucial observation that, the problem with the optimists’ case is that these two arguments are in tension with each other. If speculation is to blame for the high oil price, then higher interest rates, not lower ones, may be warranted, at least in the medium term.
Not increasing interest rates means cheaper money which led the op-ed piece to note that, Cheap money, after all, results in expensive assets, as the bubble in stocks then houses showed. This refers to asset inflation which was a feature in almost all global economies at the beginning of 2008.
The point being made is that since the price of oil has fallen to USD120, monetary policies directed at increasing interest rates to control inflation will be shelved. This may mean that spending habits will remain. This is not a good thing because the fall in oil prices is seen by many to be a temporary thing against the longer term trend of rising oil prices.
More ominously, the op-ed piece makes the observation that, As a result, the return to pumping a barrel of oil, selling it and investing the proceeds is often less than can be gained by leaving the oil in the ground and waiting for its price to rise further.
Rather than paving the way for lower interest rates, the oil price may have dropped in anticipation of higher ones.
There is a lurking suspicion that oil producers may be going slow on oil extraction given the anticipation that the price of oil will increase again over time.
Perhaps, the true moral here is that the economic planners need to use this brief breathing space to put in place programmes that will alleviate the social and economic displacement that will take place when the oil prices begin to rise again. This means that public transportation has to be improved regardless of which direction oil prices may go.
Let us not forget that food prices have not come down. Cost-push inflation is still a phenomenon that has to be urgently addressed.

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