Weekly Bank Research Center 08-25-08


On the Link between the Dollar and Oil

Stephen Roach, Head Economist, Morgan Stanley

While it is difficult to establish statistical evidence of causality, we believe that the USD and oil will likely remain negatively correlated, for various reasons. Oil prices, therefore, will remain an important – though not the only – consideration for the dollar. Specifically, lower and stable oil prices should be positive for the USD, while rising oil prices should be negative for the USD. The circle of rising oil prices and a falling dollar was vicious. In contrast, the recent reversal of these trends is virtuous and, all else equal, positive for the world. Not only will lower oil prices help to support global demand, they should also permit greater monetary flexibility to deal with lower economic growth. (There are two aspects of the nexus between oil and the dollar: their correlation and the direction of causality. We have conducted Granger Causality tests, and found that, in practice, and for the most recent period (1992-2008), the dollar tends to lead oil, rather than the other way around.) Until around 2003, higher oil prices were correlated with a stronger dollar. This was primarily because petrodollars were not only recycled back in to the US through trade but also because of financial flows: the US was dominant in every way back then, in terms of the attractiveness of its exports and assets. However, since 2004, this correlation has evaporated, and since 2006, the correlation has turned intensely negative.


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Just How Divided is the FOMC?

Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank

The divide in the Federal Open Markets Committee (FOMC) seems to have closed up somewhat in recent weeks, due probably to the drop in commodity prices helping to reassure the hawks on the committee. At the latest meeting on 5 August, only one member (Dallas Fed president Richard Fisher) voted for a rate increase, although it was feared that others would follow suit. The most inveterate hawks on the FOMC have softened their rhetoric slightly in recent weeks and are no longer talking about the need for an immediate rate increase, settling instead for a warning that a hike could come sooner than the market expects. The minutes of the FOMC meeting on 5 August will be released on Tuesday night, and it will be interesting to see how much disagreement there was between the hawks and the doves on the committee. Before then we will gain an insight into what the Fed believes to be the most important topics in the US economy right now, as this weekend brings the Fed's annual symposium at Jackson Hole. Ben Bernanke will talk about financial stability on Friday afternoon, and it will be interesting to see if he touches on the turmoil surrounding the two big mortgage lenders Fanny Mae and Freddie Mac, which flared up again during the week. An article in Barron's focused sharply on the two GSEs' problems in raising sufficient capital to counter the losses they face as a result of the downturn in the US housing market. The renewed turmoil caused the two lenders' share prices to virtually halve in the last week, and the yield on their mortgage bonds has risen further. The drastic drop in share price will make it hard for the two to raise capital through share issues, and the market is speculating about an imminent government takeover of the two institutions.


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Interest Rate Inertia: No Easy Out for Credit Adjustment

E. Silvia, Ph.D. Chief Economist, Wachovia

Sub-par economic growth combined with modest upward inflation pressures suggest the Fed is keeping the benchmark funds rate on hold. There is no easy out for creditors or debtors in our outlook. Short-term rates are likely to remain steady as the Federal Reserve faces the dual imbalance of a slow growth economy along with above-target inflation. Meanwhile credit availability, as measured by the Fed’s own Senior Loan Officer Survey, is being rapidly reduced. For the second half of this year we expect average real growth around 1.6 percent with weakness centered in the domestic economy – consumption and business investment. While inflation, as measured by the core PCE deflator, remains above the top end of the Federal Reserve’s target range. As for long rates we expect the ten-year rate in a tight 3.8 – 4.0 percent range. Yet there is significant uncertainty on both the dollar and federal deficit outlook that suggests that rates could rise above our outlook.

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Canada On The Edge of a Technical Recession

Steve Chan, Economist, TD Bank Financial Group

First, what to make of the risk that real GDP declined further in Q2? After losing much of its shine late in 2007 and then contracting by a slight 0.3% (annualized) in Q1, Canadian real GDP is expected to have grown in Q2, but just barely. Since our June forecast for a mere 0.4% gain and the Bank of Canada’s (BoC) modest July forecast of 0.8%, the data have lined up well enough against both these forecasts to keep a 0-1% outcome as the most likely. Taken together, the last pieces of economic data before next week’s release of the Q2 GDP figures did not do much to pin down whether growth in that quarter was slightly positive or slightly negative. They did, however, help to reduce the possibility of an outcome significantly off forecast, meaning Q2 real GDP growth outside the (-1.0, +1.0) range. While wholesalers finished Q2 with a good 1.0% monthly increase in June sales volumes, retailers had a harder time of it and recorded a 0.4% decline in their sales volumes during the same month. Many retailers’ overall receipts were boosted by higher prices, mostly at gasoline stations, but after stripping out price changes (which do not feed into calculations of real GDP), it becomes apparent that the retail story unfolding is one of less bang for your buck from a consumer’s standpoint. Some retailers are able to offset lower volumes with higher prices, but times aren’t rosy for the many that cannot, because of competitive pressures and/or weaker demand.

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Oil Price Fall to Boost Global Growth in 2009?

Trevor Williams, Chief Economist at Lloyds TSB Financial Markets

Oil prices have fallen back quite sharply from a peak of close to $150 a barrel just a month ago to around $112 presently. But in real terms (adjusted for price inflation) oil prices have risen in the last five years to exceed the peak levels of the oil-induced economic crisis of the late 1970s, see chart a. Oil prices and oil price shifts have the ability to have a big impact on economic growth and inflation, through the effect on incomes and from the monetary policy response. But higher oil prices elicit a strong response in another way as well - by inducing energy efficiency and technical change that reduce the amount of oil used in output and so ultimately reduce the real price of oil. That is what is implied in chart a, which shows that after peaking in the 1970s, real oil prices then fell steadily in the 1980s and remained at very low levels for the next 20 years, only starting to rise in a consistent manner since 2004.

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Compiled by David Song, Currency Analyst