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Oil markets have lost their price discovery role

Economic growth
By Paul Hodges on 13-Nov-2012

WTIvS&P Nov12.pngThe US spent $6bn on its presidential and congressional elections this year. Apart from expressing the will of the people, it may also prove valuable if it helps to highlight the danger of allowing wishful thinking to override factual evidence on the ground.

One example of this failing was last Monday’s forecast by the highly-respected US political commentator Peggy Noonan that “I think its this: a Romney win“. Noonan is one of the blog’s favourite political commentators. But she made the mistake of ignoring the data analysis undertaken by statistician Nate Silver – who correctly forecast the margin of Obama’s win, and every single one of the results in the 50 states.

Unfortunately, a similar gap has opened up in the conduct of economic policy. Most central bankers now assume that constant growth is normal. And so like Noonan, they ignore any statistical evidence suggesting they are wrong, even from a central bank with real experience of the issue, the Bank of Japan. It has just produced another detailed paper explaining how ageing populations reduce economic growth.

The result is that wishful thinking now dominates central bank policy, as the blog will discuss today in a presentation*, at our Berlin conference. The chart above highlights the problem. It shows how prices for Brent (red line), WTI (green) and the US S&P 500 Index (blue) have become highly correlated since their liquidity programmes began in October 2008:

• Historically, higher oil prices were seen as bad for the economy
• The S&P 500 would therefore fall when oil rose, and vice versa
• Now however, fundamentals of supply/demand are irrelevant
• Instead, asset prices are all moving together in correlation

The main reason for this is the mistaken but understandable fear of pension funds that these programmes will lead to higher inflation and a lower value for the US$. They therefore see oil as a ‘store of value’, and so their cash overwhelms the smaller flows of physical oil markets.

In turn, this means that no single market now knows what it is supposed to be pricing. Oil markets now account for 5% of global GDP, which has always led to recession in the past. And yet there is absolutely no fundamental reason for today’s high prices. Inventories remain high, supply is expanding rapidly, and demand is falling.

When Peggy Noonan had to face up to her mistake on Wednesday morning, it was only her personal pride that was hurt. Unfortunately for all of us, the central banks’ myopia is creating far more dangerous and longer-lasting consequences for the global economy.

* Please click here to download the presentation