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Deflationary Impact of the Oil Shock


Just as emotion is gripping the Middle East, so too has it been reintroduced back into the markets as the economic implications of higher oil prices become the hot topic of debate. The knee-jerk reaction seems to be that higher oil prices will only add to the inflation scare that so many have been obsessing about recently. Emotional times can lead to convoluted thinking, so a little perspective might be in order. First, the increases in the price of some commodities should be viewed as relative price increases, not the general increase in prices that defines inflation. Next, as oil prices have spiked over $100/barrel, take a look at things like wheat, corn, soybeans, rice, and even Dr. Copper (the metal with a Ph.D. in economics) that got everyone all excited about inflation in the first place; they have all moved in the opposite direction. For instance, rice has fallen 17% in the last two weeks. Treasury rates have fallen over 35bps over the same period. The message of the markets is clear. Rising oil prices resulting from the revolutionary contagion spreading through the Middle East should be properly viewed as an economic depressant (think of it as a tax) on a still-fragile domestic economy. If energy prices remain elevated, they can even develop into a deflationary shock, but certainly should not be viewed as a sign of pending inflation.


I'm also seeing charts of the S&P 500 popping up everywhere, showing that the index is currently flirting with breaking through the trend line established at Bernanke's late-August Jackson Hole speech, and suggesting that the long-anticipated correction is upon us. I think a better way to view the S&P 500 - still a great proxy for risk - is by framing it by the lows that marked the kickoffs of QE1 and QE2 (see below), which have been the primary drivers of the cyclical recovery. Given the Middle East jitters and the squawking of recently-emboldened inflation hawks, the index seems to be holding up okay for now, and there are a few well-defined risk management levels to alert us of a trend change..


Source: Bloomberg