In this post I present a more detailed look at developments in central banks’ balance sheets, interest rates and the oil price since mid 2006 and as of recently.
Paper and digital money are human inventions. Most people truly believe it is money that powers the society and their lives because they have never had reason to think otherwise. Money does not create energy, but it allows for faster extraction from stocks of energy (like fossil fuels) and influences consumers’ affordability of energy.
Developments in the interest rate (%) are shown by the dark blue line and plotted versus the inner right hand scale.
Since the start of the global financial crisis (GFC) in 2008 the western central banks (Fed, ECB, BoE and BoJ) have grown their total assets above $10 Trillion and added around $7 Trillion to their balance sheets in the last 7 years.
Things looked dark in 2008 so the people in leadership positions asked; “How can we stop this from imploding?”.
- From mid 2006 to mid 2007 the central banks’ interest rates were gradually set higher during which period the oil price temporarily moved lower.
- By September 2007 central banks started to cut interest rates and expand their balance sheets which coincides with the exponential growth in the oil price with its apex in the summer of 2008.
The strong growth in the oil price during 2007 and first half of 2008 has all the signatures of the formation of a bubble. And what happens to all bubbles is that they at some point bursts, and this one was no exception. Speculators may have discovered a tight supply/demand balance for oil and motivated from cheaper and more available credit taken advantage of these circumstances.
A possible cause for the collapse of the oil price may have been that the financial system became liquidity starved, draining funds away that lowered support for the oil price. As far as supplies acts as a proxy for demand, supplies declined around 3% from July to December 2008 (refer also figure 4) while the price dived 70%.
- In early October 2008 President Bush approved the Troubled Assets Relief Program (TARP) [ref also figure 2 and the sudden increase on the central banks’ balance sheets]. This happened simultaneously with a substantial cut to the interest rate which became lowered from 3.5% to 1.0%. The Fed (in concerted efforts with other central banks) started a program of quantitative easing (QE1), a tool involving assets/bond purchases, increasing money supply and thus providing liquidity to the economy.
As the financial system is virtual and thus highly responsive, it should be expected that critical movements in it will become noticeable in the real world with some time lag.
- At the turn of the year 2008/2009 the oil price started to move higher after it had hit a low late in December 2008. The liquidity injection from QE1 (and other central bank interventions) may have recovered support for the oil price. From figure 2 it can be seen that the central banks grew their assets by around $3 Trillion during these months.
Note in figure 1 how the oil price and with some time lag started to grow after the massive growth of the central banks’ balance sheets and the deep cut in the interest rates.
- On November 2010 the Fed announced a second round of quantitative easing (QE2) buying $600 Billion of Treasury securities by the end of the second quarter of 2011.
This coincided with a period where the oil price grew to $110/Bbl.
- In September 2012 a third round of quantitative easing (QE3) which was open-ended was announced by the Fed. During QE3 the oil price has remained stable at around $110/Bbl and appears only influenced from effects of seasonal demand variations.
- In December 2013 the Fed announced tapering which entails lowering their monthly bond purchases with the intention of ending it. Tapering is not tightening though the market may perceive it differently. Tapering may induce a downward momentum for the oil price.
- In March 2014 the Fed hints at interest rate rise in 2015, six months after it plans to halt its monthly bond purchasing program.
[I expect higher interest rates (like raising the Fed funds rate) will exert a downward pressure on the oil price.]
NOTE: The chart shows the gross extraction of crude oil and condensates and does not show developments in what surpluses (net energy) that becomes available for societies.
“Could the cumulative effects of the strong growth in oil prices starting back in 2004, which signaled a tighter oil supply/demand balance, upon working their way through the economies, have contributed to forcing the central banks’ to deploy their tools of lower interest rates and growing their balance sheets – measures which have mitigated some of the effects of higher priced oil?”
Stock indices are, well stock indices, and may be a poor reflection of the true state of the real economy.
Oil money image via shutterstock. Reproduced at Resilience.org with permission.