I use this gentleman’s work quite often and he is a friend and former colleague. Richard Gilhooly at TDSecurities has penned a thoughtful piece which will stimulate your brain. He suggests that we are seeing an unwind of the oil shock of the 1970s which pushed us into the inflationary spiral of that period. He wonders if we are witnessing the antipodean pole of that shock with this oil war following rapidly on the deflationary shock of the Great Recession and financial crisis.
Read and enjoy this piece by Richard Gilhooly of TDSecurities:
The 1970’s oil price shock gave rise to the inflationary decade that required remedial action from Volcker in the form of penally high interest rates and shock therapy, to change the mindset of the consumer and corporations. The Middle East used their oil weapon to make a statement on Israel and US support thereof, which led oil prices to soar and dramatically worsened an inflationary out-break that Nixon had attempted to address since 1971, with wage and price controls, while abandoning convertibility of the Dollar into gold in 1971. The second oil price shock at the end of the decade sealed the need for Volcker’s draconian monetary policy and set the scene for Central Bankers as inflation fighters over the next two decades.
Consider the 2000’s as the period of transition, from inflation fighters to soul searching through a conundrum on rates when policy appeared to lose its effectiveness as the Fed lifted rates 17 times, yet long rates remained low. It wasn’t until the deflationary shock of the financial crisis that Central Banks fully embraced their new role of inflation protagonists, a role that the BOJ belatedly but enthusiastically embraced, while the ECB has yet to be persuaded to take its first sip, but will likely find the effects intoxicating that it tries it several times.
During this deflationary period, when Central Banks have expanded their balance sheets as the private sector’s contracted, oil prices recovered with expansionary monetary policy from the $40 low at the height of the crisis. The prior peak of $150 and the ECB’s rate hike in 2008, were partly responsible for the downturn in adding pain to massive over-leveraging. Now, the situation is in reverse, with oil prices being driven lower by OPEC refusing to cut production in the face of over-supply, pressuring over-leveraged competitor producer’s and using huge reserves to remove high cost producers in order to ensure longer-term market share.
The policy amounts to the reverse of the 1970s oil price shock, which worsened an inflationary situation, while the current and recently announced policy shift argues for a massive deflationary shock when one has already been building in recent years. 2014 was the year of deflation creep, when QE from Japan had buttressed the US/UK effort and allowed Tapering, leaving Treasury yields at nominally high levels as the stealth deflation took hold and competitive devaluations became the quick answer over and above interest rate moves.
If OPEC continues to allow the price to drop, as a policy of long-term preservation, –with levels of $40 seemingly within the range of reasonable if demand has fallen to levels not seen since 2003–the opposite impulse of the 1970s shock would surely require a monetary response. It could be argued that Bernanke was the inverse-Volcker, but the latest shock, should it continue, falls on Yellen’s shoulders. And clearly Draghi faces a greater shock, while Abe’s policy of hitting 2% inflation is made all the harder with plunging oil prices to offset Yen devaluation, both moving a near equal magnitude of 50%.
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