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Oil Prices and Interest Rates

March 1st, 2022 2:35 PM by Gregg Mower

As I write this blog, it really helps to have some years lived under my belt.  Although I was only 9 in 1972, I was there and can remember the gas lines and high-interest rates.  The reason why this is important is that history has a way of repeating itself no matter how hard people try to erase it.  Regardless, you are here to read about where interest rates are headed and maybe even oil prices.  As I write this blog Russia is in the process of invading Ukraine.  Russia is one of the largest producers of oil in the world currently and the United States gets about 1/3 of its oil from Russia and Europe gets about 50% of its oil from Russia.  Currently, the US and Europe have imposed sanctions on Russia that is basically crippling their economy except for the oil the world is purchasing from them.    As Russia’s currency and banking system is being crushed by the sanctions, the oil is still flowing out of Russia to Europe and the US to the tune of 100 million barrels a day and at $100.00 a barrel (the current price of oil) Russia, especially Putin, are still making money every day.  At some point, either Europe and the US will stop buying the oil and financing the war, or Russia will turn it off and choke Europe with gas prices so high it will cripple the European economy and will hurt the US economy.  

This should be opening our eyes to the severity of this conflict, not to mention Putin has put his nuclear arsenal on the ready.  So, what will happen to interest rates here at home?  This question has to be answered with a history lesson.  First, let's look at where we were before Russia invaded Ukraine.  Here in the US, we were seeing a high inflation number (6%) before the invasion, and this was due to many factors but going to core economics we were seeing a high demand for goods and services and a diminished supply of goods and services which caused prices to go up.  That is simple economics, now add a war where the supply of oil will be diminished so the price of fuel will be higher.  The goods being delivered to our stores will cost significantly more to get them there so the price of those goods will have to go up to compensate for the delivery charges.     Here is where history comes in, as in the past Interest Rates have been raised to slow the demand for goods and services thus slowing down a heated economy.   In our current situation, we have high demand, high prices, and high inflation with a short-term outlook for even higher costs as delivery costs rise with the price of oil increases.

In 1972 we had rising costs and an oil supply shortage that caused higher delivery costs with no war.   By the end of the 1970’s we also had interest rates for home loans that got as high as 20%.  What we also had during the 1970s was an expanding economy with high demand for labor.  Remember, there were no computers back then, so everything was done by humans, so you had to pay good wages to get good humans to work for you, so we had wage inflation that kept up with the inflation of the time.  Sound familiar, it should as currently we have a high demand for labor, and we have wage inflation.  So, if history repeats itself, we should have high-interest rates.  The wild card here is the war.  If we get involved with the war our economy will heat up even more, but what we have going for us is the fact that the US Dollar is currently the world currency giving the US a stronghold.  This could change if China and Russia joined forces, a discussion our leaders.   

Why then are interest rates relatively stable in today’s world in the low range and what will happen to rates with war and then without a war?  Let’s break this down and use history to help us.  If Russian oil is cut off, we will have higher prices across the board which is inflation, but will the Federal Reserve (the Fed) raise interest rates to slow down the economy?  My belief is that the Fed will have to raise interest rates to curb demand, however, they will have to be very careful not to mix up demand inflation for goods and services to the abnormal price increases of oil.  The Fed will be tasked with separating consumer demand for goods and services that is normal to the price increase of oil.  The price of oil increasing is not a function of demand for it, it is a supply-side issue that will have to be calculated.  As I write this blog the stock market is going down and interest rates are lowering a bit.  The reason for interest rates going down short-term is due to a flight to quality where when the Stock market falls rapidly stock traders move away from highly volatile stocks to the steadiness of US Treasury Bonds.  As the demand for steady interest rates bonds increase the price of those bonds increases thus lowering interest rates in the short term.  In the past, the Fed has raised interest rates to slow down the economy to curb inflation.  What we have currently is a slow economy with high demand and high inflation or as they called in the 1970’s Stagflation.  

History has shown that war brings nations out of situations like this.  This war is like nothing I have seen in my life where you have a superpower (Russia) being an aggressor.  The only historical time that can be looked at is Germany in the late 1930s when they were severely depressed coming out of the loss of World War 1.  Germany stimulated their economy by starting up its war machine and WWII was started and pulled the entire world out of a depression.  I can only hope that the current actions of Russia don't start WWIII.  In the meantime, we can only pray that this situation does not escalate even further, but if it does God help us.  Assuming this goes on for a while and oil is choked off from Russia we will have higher prices for all goods and services and in order to slow demand will be to raise interest rates.  If the war ends and the oil continues to flow, then we still have pent-up demand and inflation.  The Fed will have to raise interest rates to offset this.  The dance is going to be where the right interest rate point is that keeps the economy moving at a sustainable rate without run-away inflation or stagnating the economy.  This is no easy task for the Fed as there is no real point in history where we have had all of these factors at once.  My belief is that we will see higher interest rates due to the demand factors seen prior to the war with Russia and Ukraine.  I believe interest rates for home loans will equalize around 5-6% by the end of all this without full-on WW3.  We have to be positive with regards to war as not only do we have to watch Russia, but China is also looming out there and that scares me more than Russia as they are closer to the West coast of the US than Russia.  In conclusion, I see the underlying economy in the US as heating up without our involvement in a war, if we get involved demand for labor will go up significantly and so will wage inflation to attract workers to build aircraft, munitions, and military items.  The Fed will have an almost impossible task if that is the case.  If we can stay out of war and we go back to what was happening in the economy prior to the conflict the Fed will have to raise interest rates until supply catches up with demand.  In these uncertain times, there is no right answer we have to look at history to see where we are headed and most importantly as Americans we need to stick together.  

 

Posted by Gregg Mower on March 1st, 2022 2:35 PM

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