The Economist and Goldman on oil and the dollar

I liked the lede of this week’s economist story on the Fed, the dollar and oil:

“THE spirit of St Augustine hovered over the Federal Reserve this week. “Oh Lord, let us stop cutting interest rates, but not yet”

And I liked the analysis even more – perhaps because it draws on an excellent Goldman Research paper by Jens Nordvig and Jeffrey Currie.

The Economist alludes what I think is the most important point: dollar weakness and oil strength and both are manifestations of the fact that global growth has been far stronger than US growth. Weak US growth translates into dollar weakness. Strong growth outside the US – particularly in emerging economies – translates into ongoing growth in demand for oil.

All the more so because many of the most rapidly growing economies in the world keep domestic oil prices below world market prices (this is true for the oil exporters like Russia and Saudi Arabia as well as oil importers like China), helping to keep demand growth up. Combine growing economies with stagnant supply and, well, prices have to rise to bring demand in line with supply.

The impact of strong global growth on oil – and commodities more generally – is one reason why strong growth outside the US doesn’t clearly help to reduce the overall US trade deficit. Strong growth abroad means it is easier for the US to sell more goods abroad. It also increases the price of the United States’ agricultural exports. Alas, those aren’t all that large a share of total exports anymore, in part because a lot of corn is buying converted into ethanol and burned in American SUVs. But strong growth abroad also increases the price of oil. And the US now imports a lot of oil. That means it spends a ton of money on imported oil. Way more than in the 70s in absolute terms, and even relative to world GDP.

The Goldman paper suggests that the United States’ energy inefficiency, its modest exports to the oil-exporting region and a reduced willingness on the part of the oil exporting economies to hold dollars – together with the Fed’s tendency to target core inflation while the ECB targets absolute inflation – explains why the dollar has tended to fall when oil rises. Goldman found that the negative correlation with between the dollar and oil holds even if oil is priced in euros or a basket of global currencies – i.e. a high real oil prices contribute to a weak dollar more than a weak dollar contributes to a high dollar price of oil. The Economist:

“So is the weaker dollar driving oil prices up or are high oil prices driving the dollar down? The Goldman analysts argue the latter because oil exporters import more from Europe than America and hold less of their oil revenues in dollars. A second factor lies with central banks. Because the Fed focuses on “core” inflation (which excludes food and fuel), whereas the ECB targets overall inflation, America’s central bank runs a looser policy in response to higher oil prices, thus pushing the dollar down.”

This negative correlation obviously makes monetary policy particularly difficult for those oil exporters that insist on pegging their currency to the dollar. They are effectively importing a doubly pro-cyclical policy – currency weakness together with low US rates – at a time when high real oil prices are producing a boom. No wonder inflation is now at or above 10% in almost all the big oil exporters that peg to the dollar (or even a dollar-euro basket).

Saudi Arabia just recently joined the club, if 9.6% y/y inflation is rounded up. Though I guess it is possible to argue that 10% inflation isn’t that bad, as Saudi inflation was closer to 30% back in the 70s …

I am particularly interested in one part of Goldman’s argument – the claim that oil exporters hold less of their oil revenue now in dollars. If there is one thing I would like to know even more than the dollar share of China’s reserves, it is what fraction of the overall increase in the official assets of the oil exporting economies that is going into dollars. We know that Russia is putting a lower share of its assets into dollar now than in 2005. Norway too – though the shift is more modest. Iran and Venezuela have likely moved in the same direction, though they are rather less transparent than Russia and Norway.

But we don’t know what the Gulf has been doing. And at current oil prices, the Gulf really matters.

The big Gulf sovereign funds (ADIA, KIA, QIA) seem to hold about the same share of their assets in dollars as Russia, or maybe just a bit less.

But recently the growth in the assets of the Gulf’s central banks, including the Saudi Arabian Monetary Agency (SAMA), has been faster than the growth in the assets of the Gulf’s sovereign funds. And they likely still hold most of their reserves in dollars.

That is why Rachel Ziemba and I argued that the Gulf as a whole hasn’t been able to diversify away from the dollar, even if individual institutions have.

However, our argument depends on a lot of assumptions and inferences. We don’t know for sure.

And the answer matters now more than ever.

The Saudi central bank added $40b to its foreign assets in the first quarter. If oil stays where it is now, the Saudis could add close to the $200b to their foreign assets this year. That is a lot for a country of maybe 25 million people; only a country of 1.3 billion people will do more …