The Fed’s economic views on inflation, sentiment, growth, economic drivers, and Keynesian stimulus have been proven wrong so many times, in so many ways, yet the Fed never discards its models that don’t work. Here is a beauty that shows the absurdity of inflation expectations and the price of oil.
Please consider the St. Louis Fed article What Future Oil Price Is Consistent with Current Inflation Expectations? by By Alejandro Badel, Economist, and Joseph McGillicuddy, Research Associate.
Oil prices have continued to decline over the past few months, dropping to nearly $30 per barrel by last December. This drop coincided with a fall in breakeven inflation expectations, as measured using the premium paid for Treasury inflation-protected securities (TIPS) over standard Treasury bonds.
If the fall in breakeven inflation rates reflects a fall in actual inflation expectations, and assuming this fall is largely driven by a fall in oil price expectations, then we can ask the following question: How low would future oil prices have to fall to validate current breakeven inflation rates?
The figure below shows a backtest of our model from July 2014 to December 2015. As demonstrated by the figure, the model predicts the actual path of annual CPI inflation over this time period quite well.
Results
We calculated the future path of the CPI over the next 10 years (starting in January 2016) that would be consistent with breakeven inflation expectations at horizons of one year through 10 years. Then, using an annual growth rate of 2.87 percent for the “all items less energy” component and using 0.46 for the elasticity of the energy component with respect to oil prices, we backed out the future path of oil prices that would produce this future path of the CPI. The figure below displays the implied oil price series and compares it to the future oil prices implied by West Texas Intermediate crude oil futures.
Conclusion
According to our calculations, oil prices would need to fall to $0 per barrel by mid-2019 in order to validate current inflation expectations. After that, there is no oil price that would allow our model to predict a CPI path consistent with December 2015 breakeven inflation expectations. This implied path of oil prices is very different from the path of oil prices implied by futures contracts, which rises to more than $50 per barrel by mid-2019.
We state some potential explanations for our results:
- Expectations for the future growth of the other CPI components besides energy may be lower than the annual rate of 2.87 percent we assumed in our model.
- The recent movements in breakeven inflation expectations may have been caused by something other than the decline in oil prices. It is even possible that a third variable is driving the decline in both.
- Investors may expect the relationship between oil price and the CPI energy component to change in the future. (This would be despite the strong relationship seen over the past 20 years, shown in the second figure in our previous blog post.)
- Changes in the inflation risk premium for bonds that are not inflation-protected and/or changes in the liquidity premium for TIPS may be distorting breakeven inflation expectations in the last few months.
Mish Alternate Proposals
- The model was dependent on China maintaining unrealistically high growth perpetually.
- The model does not work well in periods of global demographic shifts (China, US, Europe)
- The model does not work well in deflationary conditions.
- The model does not work well in periods of global rebalancing.
- Twenty years is not a long enough timeline from which to create an economic model.
- The Fed’s inflation expectations model is a curve-fitting illusion. It never really worked in the first place.
All of those are possible, but I believe points 1, 5, and 6 are the key factors, with emphasis on points 5 and 6.
Fed economists are not predicting $0 oil. Rather $0 is simply what their model says it should be. Regardless of reason, we now have proof of the absurdity of their inflation expectations model.
Mike “Mish” Shedlock
Here is some interesting information regarding the price of oil:
HOW HIGH OIL PRICES WILL PERMANENTLY CAP ECONOMIC GROWTH
For most of the last century, cheap oil powered global economic growth. But in the last decade, the price of oil production has quadrupled, and that shift will permanently shackle the growth potential of the world’s economies.
http://www.bloomberg.com/news/articles/2012-09-23/how-high-oil-prices-will-permanently-cap-economic-growth
BUT OIL PRODUCERS NEED $100+ OIL
Steven Kopits from Douglas-Westwood said the productivity of new capital spending has fallen by a factor of five since 2000. “The vast majority of public oil and gas companies require oil prices of over $100 to achieve positive free cash flow under current capex and dividend programmes. Nearly half of the industry needs more than $120,” he said
http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11024845/Oil-and-gas-company-debt-soars-to-danger-levels-to-cover-shortfall-in-cash.html
hahaha…i can tell you one thing…the price of oil will not be zero …ever..because it actually exists and has utility… all this proves to me is that the model is not complete and that we should not waste any time trying to explain why some pencil neck can’t do maths.
WELL….(LOL) THE KEYSENIAN AND WHATEVER MODELS ARE ALWAYS WRONG BECAUSE THE GOVT “JURY RIGS” THE STATS. YOU KNOW, JUNK IN IS JUNK OUT.
$0.00 FOR A BARREL OF OIL PROBABLY TRANSLATES TO ABOUT $6.50 AT THE PUMP.
WELL, (NO PUN INTENDED) WITH PUTIN DEVELOPING OIL FIELDS ALL AROUND THE WORLD WON’T BE TOO MANY COUNTRIES THAT WILL NEED TO IMPORT OIL. SO TECHNICALLY IF YOU SELL YOUR CITIZNES THEIR OWN OIL THEN THERE IS NO PRICE TO IT, RIGHT?
BUT THEN THAT PUTS AMERICIANS INTO A “PEAK OIL” SITUATION. SO, WE HAD DAMN BETTER GET BACK TO MANUFACTURING STUFF SO WE CAN AFFORD CHEAP OIL AND NOT THAT FRACKING STUFF.
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Image result for DEFINE JURY RIGGING
Jury rigging refers to makeshift repairs or temporary contrivances, made with only the tools and materials that happen to be on hand, originally a nautical term. On sailing ships, a jury rig is a replacement mast and yards (which hold the ship’s rigging) improvised in case of damage or loss of the original mast
HOW HIGH OIL PRICES WILL PERMANENTLY CAP ECONOMIC GROWTH
For most of the last century, cheap oil powered global economic growth. But in the last decade, the price of oil production has quadrupled, and that shift will permanently shackle the growth potential of the world’s economies.
http://www.bloomberg.com/news/articles/2012-09-23/how-high-oil-prices-will-permanently-cap-economic-growth
BUT OIL PRODUCERS NEED $100+ OIL
Steven Kopits from Douglas-Westwood said the productivity of new capital spending has fallen by a factor of five since 2000. “The vast majority of public oil and gas companies require oil prices of over $100 to achieve positive free cash flow under current capex and dividend programmes. Nearly half of the industry needs more than $120,” he said
http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11024845/Oil-and-gas-company-debt-soars-to-danger-levels-to-cover-shortfall-in-cash.html
The notion that there is some general price level is ridiculous. The notion that price changes due to changes in supply and/or demand represents inflation or deflation is equally ridiculous. Both notions begin with the hubristic impulse that empiricism has something worthwhile to say about economics–the activity and interaction of billions of humans with billions upon billions of variables involved (many hidden).
Austrians know what’s going on without testing or measuring a single thing,,, but hey. if you’re an economist, you’ve got to justify that $200,000 sinecure somehow, and common sense just isn’t going to cut it. Hey, let’s make some esoteric models instead, with math ‘n shit!
Except, of course, those times when… the weather is to blame.
Koch refineries charge to process high sulfur crude. That is negative value. Venezuela cannot pump nor sell heavy crude without mixing it with a lighter crude and Venezuela cannot afford the light crude. That is negative value. Mexico is selling high sulfur crude below cost of production. That is negative value. Contango oil may have negative value. Oil storage is expensive.
I fondly recall National Geographic’s “the end of cheap oil” declaration.
“Cheap” is, of course a relative term…:-)
We are out of cheap oil:
Steven Kopits from Douglas-Westwood said the productivity of new capital spending has fallen by a factor of five since 2000. “The vast majority of public oil and gas companies require oil prices of over $100 to achieve positive free cash flow under current capex and dividend programmes. Nearly half of the industry needs more than $120,” he said
http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11024845/Oil-and-gas-company-debt-soars-to-danger-levels-to-cover-shortfall-in-cash.html
This was predicted in the Scientific American:
The End of Cheap Oil
Global production of conventional oil will begin to decline sooner than most people think, probably within 10 years — By Colin J. Campbell, Jean H. Laherrre on March 1, 1998
The articles on SA is behind a pay wall – you can read it here http://www.dieoff.org/page140.htm
Note: Oil hit a record high of $147 in July 2008. How’s that for a prediction!
Garbage in, garbage out.
That in a nutshell describes most of the Fed’s “models”.
“Did you know that disco record sales were up 400% for the year ending 1976? If these trends continue… A-y-y-y!”
–Disco Stu