The 'Oil Prices Create Inflation' Myth

Sometimes you really have to wonder – Ben Bernanke is one of the most respected figures in mainstream economics today – in terms of publications in mainstream economic journals, he still ranks in the top ten, in spite of having left academe for a government job some time ago.


So it would be fair to say that he's an 'authority'. God help us all.

Since he apparently felt compelled to react to the growing tide of criticism with regards to the sharp rise in commodity prices his inflationary policies have helped to ignite, he once again came up with a real zinger in his recent Congressional testimony. As the Washington Post reports: 'Fed will respond if oil prices trigger inflation, Bernanke says'.

Well, no Mr. Helicopter Pilot, higher oil prices can definitely not 'trigger inflation'.

We're not quite sure if this is just part of the propaganda tactics of the Fed or if he really means it, but if he does mean it, then he should maybe go back to school. Rising prices are not 'inflation', and they can also not 'trigger inflation'. They are an effect of inflation  – the very inflation of the money supply the Fed is responsible for. So we have two errors here – firstly, an erroneous definition (inflation is the increase in the money supply; rising prices are not inflation, but an effect of inflation) and secondly the mistaken assumption that higher prices can be a 'cause' of inflation. What Bernanke means by that is,  according to the Fed's own publications on the topic of inflation, accepted lore at the central bank. The idea is that a rise in energy prices can 'push' other prices in the economy up. However, this is simply not possible, ceteris paribus.

The only way a widespread loss in money's purchasing power can occur is if the Fed or the commercial banks or both increase its supply. If the money supply were to remain stable, higher energy prices could never ever raise prices elsewhere in the economy. The exact opposite would happen: prices elsewhere in the economy would need to fall to accommodate the increase in energy prices if people were not to curb their energy consumption commensurately.  With a fixed supply of money, rising prices in one sector of the economy must  , perforce, lead to falling prices elsewhere, as demand for other goods would need to be curtailed accordingly.

There is however one reason for which Bernanke's concern is not entirely inappropriate: the fact that he has already pumped up the money supply enormously. As more and more evidence of the long range effects of this money supply inflation comes to the fore – higher oil prices representing one such piece of evidence – there could be a sudden reappraisal by economic actors of the likely future loss of purchasing power of money. Such a reappraisal may well lead to a more urgent discounting of these expected future losses of purchasing power, and would accordingly lower the demand for money. In that case, we could see the effects of inflation accelerate.

The important point remains  however that without the preceding increase in the money supply for which Bernanke and his colleagues at the Fed are solely responsible, such an event could not possibly occur.


More Inflation Promised

While Bernanke goes around telling people that the Fed's activities only produce 'good inflation' (i.e., they raise stock prices, which allegedly is to be considered an unalloyed positive – never mind that when titles to capital start bubbling up we can safely conclude that relative prices are being distorted by  too low interest rates), while rising commodity prices are supposedly the result of 'growth in emerging economies', there are some notable people who disagree.

Before we get to that, note that Bernanke received support from a recent OECD report that asserts that 'Real Demand Is Driving Commodity Prices'. Well, yes, and – so what? Is there such a thing as 'unreal demand'? Naturally when central banks inflate the money supply, the money will flow to those assets that have a 'good story' behind them that promises to produce big gains. Commodities have such a story behind them (rising demand from China and a 20 year long bear market from 1980 to 2000 that meant that very little investment in new sources of supply was made).

Nonetheless, these prices could not possibly rise in a broad-based fashion if not for loose monetary policy being practiced nearly everywhere in the world. In the vast bulk of countries real interest rates are currently negative, removing a large part of the opportunity cost that normally attends commodity hoarding.

Not surprisingly, one notable dissenter is once again Thomas Hoenig, who recently remarked that there actually is a connection between loose monetary policy and rising commodity prices (duh). It is quite astonishing that he seems to be the only central banker in the whole wide world capable of acknowledging this.


“Some of the jump in commodity prices reflects rising world growth and supply disruptions, but Federal Reserve Bank of Kansas City President Thomas Hoenig said “if you engage in a highly accommodative policy and you are the world’s reserve currency .. that does facilitate the demand side.”

Any economic event is more than one thing,” Hoenig said, but “we know both have a role to play.” He added “we have to be sensitive to our monetary policy actions” and their impact in the U.S. and elsewhere, as “the rest of the world does have an impact back on us.”

Hoenig again advocated that the Fed should move interest rates higher from their current near-zero% mark, given that the economy is recovering and no longer needs a policy that was formulated to deal with an economic emergency.

“I really want to take away the punch bowl before the room gets drunk, because this punch is, I think, a little bit spiked,” the official said. “I’m not for tight monetary policy, I’m for non-zero% monetary policy,” he said.”


(our emphasis)

This little sentence we highlighted above is quite important actually. If one scrutinizes the 'data' as the Fed routinely does, i.e., if one looks at the facts of  economic history, then what stands out is that at any given point in time, there are so many things influencing the state of the economy that it is impossible to come to any firm theoretical conclusions from such observations. We are therefore left with employing logic and rational deduction. That alone tells us that there is a connection between easy money and rising prices.

Meanwhile, Bernanke continues to wear his 'dove's hat' – as Bloomberg reports, 'Bernanke Doesn’t Rule Out More Bond Buying to Aid Economy':


“Federal Reserve Chairman Ben S. Bernanke didn’t rule out expanding the central bank’s asset purchases aimed at stimulating the economy, saying he doesn’t want to see the nation relapse into a recession.

Asked at a House Financial Services Committee hearing today what conditions would warrant a third round of so-called quantitative easing, Bernanke said that “what we’d like to see is a sustainable recovery. We don’t want to see the economy falling back into a double dip or to a stall-out.”

Bernanke’s testimony today and yesterday signaled that he will keep the Fed on course to complete $600 billion of Treasury purchases through June under the second round of quantitative easing, a policy criticized by Republican lawmakers as risking an inflation surge. He’s avoided saying what the central bank may do after that.

A third round of purchases “has to be a decision” of the Federal Open Market Committee, and “it depends again on our mandate” for stable prices and maximum employment, Bernanke said in response to Texas Representative Jeb Hensarling, the House panel’s vice chairman and a critic of QE2.“


Of course, while the Fed can devalue the money it issues, and thereby create an inflationary illusion – if you will,  a Potemkin village of a recovery – it can not create any wealth or truly sustainable economic growth. It can however  help with the blowing of bubbles that will later collapse again.

Why is Bernanke so insistent to continue with the easy money policy? There are two major reasons for this. For one thing, judging from his writings and speeches referencing Japan's long 'soft depression', he is convinced that the BoJ was 'too timid' and stopped 'too early' with its extraordinary money printing measures. The other reason is the fact that the US banking system remains completely zombified. Below is an interview the well-spoken and thoughtful manager of Westwood Capital, Dan Alpert, has given to Bloomberg recently.

We strongly recommend listening to this interview in its entirety.  Alpert echoes the concerns our friend Ramsey Su has frequently raised in these pages with regards to the housing market, with a special focus on the US banking system. As Alpert notes, nearly $3 trillion in mortgage loans remain on the books of US banks, with a large and growing portion thereof extended to 'underwater' borrowers. The 'extend and pretend' policy that has begun in 2009 with the suspension of mark-to-market rules serves to kick the can down the road in the hope that over time, the housing market will return to a state that allows these loans to get better. This is exactly the method that was pursued in Japan over the past two decades , with the well-known results of never-ending economic stagnation and a fiscal debt that has grown to the sky.

Evidently, all the criticisms leveled by US policymakers at Japan in recent years are now revealed as utter hypocrisy.






Meanwhile, across the pond, Mervyn King thinks that if the BoE were to hike rates from the current 0.5% in view of UK CPI closing in on a 5% annualized rate would be 'self-defeating'.


Bank of England Governor Mervyn King said increasing the benchmark interest rate to make a gesture in the fight against inflation would be “self-defeating,” as he predicted above-target price gains will persist through 2011.

“To raise interest rates just to make a signal, a gesture is self-defeating,” King told lawmakers in London today. It would “undermine the whole point of this framework,” he added.

Central bank officials split four ways on policy last month amid differences on the outlook for inflation after consumer prices rose an annual 4 percent in January, double the bank’s target. King said today there was no evidence that businesses and households think high inflation is here to stay.

“I don’t believe we’ve yet seen significant evidence of a pickup in medium-term inflation expectations,” he told Parliament’s cross-party Treasury Committee. Still, it’s “reasonable to believe that if we continue to experience above- target inflation for long enough there could be an upside risk to inflation expectations.” 


King also presides over an insolvent banking cartel that has in large part become a ward of the State. Still, these rationalizations for keeping the loose monetary policy in place in spite of the strong evidence of its effects on prices are quite something. As we have noted before, 'inflation expectations' can not by themselves 'create inflation'. The sine qua non is always an increase in the money supply. In addition, unless Mr. King is a mind reader, he can not know what businesses and households really think.  We kind of doubt that the citizenry, whose real incomes are under severe pressure, is as  sanguine about rising prices as Mr. King is. If anything, it appears to us that his current policy is what will prove to be 'self-defeating', by leading to more waste of scarce resources and thereby further undermining true wealth creation in the UK economy.

All of this is of course said with the caveat that in an ideal world with a true free market system,  neither Mr. King's nor Mr. Bernanke's job would actually exist.  A system of free market capitalism does not require a central economic planning agency fixing the price and directing the supply of money. The existence of such institutions is in fact proof positive that we currently do not have a system of free market capitalism in place.

Meanwhile, the ECB, which due to its supranational status and sole mandate (its only official mandate is the preserve the internal and external value of the currency) has at least in theory a slight advantage over e.g. the Fed with its entirely impossible to fulfill dual mandate, has begun to sound more hawkish lately. ECB president Jean-Claude Trichet allegedly 'shocked the markets' by intimating that there may be a 25 basis point hike in the ECB's administered interest rate from its current level of 1%. We'll see about that. A 25 basis point rate hike won't make much of a difference, but aside from that, the impending bailout of Portugal and the ongoing disintegration of Greece may upset any tightening plans before they can come to fruition. A likely reason for the ECB's more hawkish stance was that prices in the euro area once again rose faster than forecast.





As a follow-up to a recent missive referencing the crash in Saudi Arabia's stock market, we show two charts of the Saudi Arabian Al-Tadawul All Share Index. As can be seen on the long term chart (which includes an overlay of the Nasdaq, algning the tops in these two markets) , this was a typical major stock market bubble that has turned into a long term secular bear market. Currently it appears to be entering the 'capitulation phase'.




A chart of Saudi Arabia's Al-Tadawul Index since the 2009 low – the red line represents the average buy price of investors that have bought shares in Saudi Arabia since the March 2009 low. Relative to this average, they are now severely 'underwater' – click for higher resolution.



A long term chart of the Al-Tadawul Index with the Nasdaq Index overlaid, aligning the Nasdaq's year 2000 top with the Al-Tadawul Index top in the mid 2000ds. We see here the typical self-similar patterns of major bubbles followed by secular bear markets – click for higher resolution.


Charts via Citigroup.




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7 Responses to “Bernanke and King Defending Their Policies”

  • RedQueenRace:

    After being in Washington as long as he has I wonder if Bernanke has figured out why the PTB (many from Goldman) support his economic theories and approach. Is he now part of the game or the world’s biggest tool?

  • China would collapse in a week if they tried to make the yuan the reserve.

  • Floyd:

    Please help me understand.
    (I’d appreciate if you could point to flaws in the following text).

    Let’s suppose there is a substance, called “oil”, that is a component of any good consumed.
    A simplistic model would suggest that shortage of oil would lead to decrease in the overall amount of goods produced.
    While in reality things are more complex, for example the mixture of goods would adjust to shortage of oil, given severe shortage the overall amount of goods produced must decline.
    If the shortage is really bad, it could lead to extreme situations up to “starvation”. Isn’t it?
    A corollary is that the overall economic activity decreases in response to severe shortage of oil.

    Now, let’s turn our attention to inflation, which is defined as increase in the supply of currency.
    Suppose that the currency stock is fixed (there is no FRB, gg is the unit of currency, etc.), then would its quantity grow relatively to declining economic activity?
    Wouldn’t that lead to the broad price level to go up (akin to monetary inflation)?

    I suspect that in debt based financial system increasing oil prices have deflationary impact as well, due to the increased challenge of debtors to service their debts.
    I realize that predicting which force would be stronger is futile as we have overwhelming government meddling in the finance systems.


  • Specterx:

    “While Bernanke goes around telling people that the Fed’s activities only produce ‘good inflation’ (i.e., they raise stock prices, which allegedly is to be considered an unalloyed positive – never mind that when titles to capital start bubbling up we can safely conclude that relative prices are being distorted by too low interest rates), while rising commodity prices are supposedly the result of ‘growth in emerging economies’, there are some notable people who disagree.”

    It seems highly questionable whether the Fed’s actions are having any direct physical effect on either the stock market or commodities. If the “printed” money is simply piling up as idle reserve balances, and lower interest rates are failing to stimulate credit expansion, then inflation (Austrian inflation) is not taking place.

    If so then the rise in commodity prices (ex PMs), stock prices, etc. are effects of 1) simple speculation, and 2) credit expansion and inflation elsewhere in the world – but that’s not Bernanke’s doing, at least not directly.

    • Alan Simpson:

      When a country or countries in this case devalue their currency then fixed assets, ( commodities ), will rise this is not rocket science.

      No amount of obfuscation and wriggling will change this, capital, in it’s real sense, will always find it’s own level.

  • Specterx:

    “prices elsewhere in the economy would need to fall to accommodate the increase in energy prices if people were not to curb their energy consumption commensurately. With a fixed supply of money, rising prices in one sector of the economy must , perforce, lead to falling prices elsewhere, as demand for other goods would need to be curtailed accordingly.”

    I’m not sure why this is correct. Rising oil prices increase production costs for everything that uses oil as an input – which is just about everything. This can be absorbed by lower profit margins at some stage of production, or passed on as higher consumer prices, or some combo of the two.

    If the oil price is rising because it simply requires more resources to extract a barrel of oil (i.e. more expensive, less efficient) then it seems this would lead to a sustained general rise in prices, unless or until other efficiencies or substitutions make good the difference. Much like rising productivity leads to falling prices, falling productivity leads to rising prices (or less of a fall than would otherwise by the case).

  • Alan Simpson:

    Sigh. Central Banks are indulging in, “Magical thinking”, of the finest quality. ” and then a miracle happened “, appears to be fiscal policy these days.

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