Friday, June 10 2022

The latest FOMC rate hike cycle has begun, following the March 15-16 meeting in which the Federal Reserve raised rates by 25 basis points (bps). In the week following the rate hike announcement (through March 25), first-month WTI crude oil prices at CME Group rose nearly 20%.

With these recent moves, it’s interesting to look back at what has happened to the price of crude oil in the past during past rate hike cycles. Since August 1983, there have been six cycles of rate hikes in the United States. The Fed’s FOMC raised interest rates a varying number of times for different durations during these cycles, but all of these periods included at least two rate hikes. In the six months following the first rise in these cycles, the price of crude oil rose an average of 16.06%; it increased in five of these six-month periods following the start of a hiking cycle.

Chart: WTI price change following rate hikes

If you include the first rise of this cycle and the movement in the price of WTI since the rise, this average rises to 16.60%.

Chart: Average change in WTI price after March 2022 rate hike

Chart: Average change in WTI price after March 2022 rate hike

So, is crude oil rising because of rate hikes, or is it just a coincidence born out of circumstances with no causal relationship? The simple answer is…both.

When you see stats like this, you might start to wonder if Fed actions could be the spark that drives the price of a commodity higher. In order to ask this question, it seems relevant to think about why the Fed is raising rates in the first place, and to do that, we need to look at the Fed’s mandate.

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The Fed’s tenure was prompted by economic events in the 1970s, a period marked by the presence of high inflation and high unemployment, otherwise known as stagflation. The Federal Reserve Reform Act of 1977, which acted as a de facto addendum to the original Federal Reserve Act of Congress of 1913, clarified the roles of the Board of Governors and the Federal Open Market Committee, which included maximum employment targets as well as moderate long-term interest rates and stable prices. This has become universally known as the Fed’s “dual mandate”. One of the tools they use to achieve their dual mandate is the level of the federal funds rate.

The latest unemployment rate reading is below 4%, which many economists believe is either full employment or close to full employment, so the first part of the dual mandate (at least temporarily) has been achieved. . However, the second part – stable prices – is currently of concern. The most recent reading of year-over-year PCE price data shows inflation hovering near 8%. Inflation growth at 8% is anything but stable, which means that to achieve stable prices, the Fed has found it necessary to raise interest rates. But how do higher interest rates stabilize prices? Higher interest rates tighten financial conditions and, in theory, slow the economy and keep demand in check. Logically, a fall in demand for the same number of goods over time means a fall in prices.

The hypothesis is that if the economy slows, people will spend less in their daily lives and therefore use less of everything, including gasoline in their cars and jet fuel in their planes since people under financial pressure will make less trips. Businesses will become less busy, which means those businesses will use less energy.

Looking at the chart below, however, it appears that rising interest rates are only slightly affecting crude oil prices, at least in the medium term. In the 12 months since the first rise in cycles dating back to 1983, crude oil prices rose an additional 12.24% on average when measured from the six-month benchmark.

Chart: WTI price change six months after a first-order rise

Chart: WTI price change six months after a first-order rise

The data seems to show that even though crude oil is one of the drivers of inflation, it may not be directly affected positively or negatively by the real change in short and medium-term rates. Many other factors influence the price of crude oil, including geopolitics and sudden increases in supply or demand. It could just be that an integral part of inflation is the price of energy which, of course, includes crude oil. Generally, rising crude oil prices are either a large component of the cause of broader inflation, or rising oil prices are a function of a strong economy and increased demand.

Crude oil prices generally rise six months and twelve months after the start of a rate hike cycle, but this relationship is not necessarily causal.

Read more articles like this on OpenMarkets

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