Tuesday, December 9, 2008

This is not deflation

The top chart shows the inflation-adjusted price of Arab Light crude oil (adjusted using the Personal Consumption Expenditures Deflator). Oil has plunged since July, as have most commodity prices, and this in turn has sparked much discussion about deflation. A true deflation, however, is when all prices decline, not just some, and we aren't seeing that at all; witness the continued positive increase in the ex-energy (core) measures of inflation. Moreover, although the decline in oil has been fairly spectacular, oil is still, in real terms, much higher than at any time from 1986-2005. That's another way of saying that energy prices have, even net of their recent declines, risen by more than the average price level have since 1985.

The second chart compares the price of oil to the price of gold. Since gold tends to hold its real value well over time and tends to foreshadow future changes in the price level, this may give us a better feel for what is really going on with the price of oil. Compared to gold, oil is trading very close to its long-term average price; it's neither expensive nor cheap, and that's roughly the same message of the top chart.

So the take-away I get from this is that the oil price bubble has popped, and oil is now trading at a much more reasonable level from an historical perspective and relative to other prices. As John Tamny writes, it can be very confusing when prices rise and fall dramatically as they have done in recent years. This contributes to the uncertainty and lack of confidence which is affecting the entire economy. It's good that oil is back to more reasonable levels, but it's bad that the price of oil has been so volatile. In the end, the message is that this is a story that has more to do with volatility and uncertainty than it does with deflation.


Mark Gerber said...

Hi Scott,
Do you happen to have a chart that shows the price of USA housing in gold? I think that would be an interesting way to gauge where we stand in historical terms since housing is at the epicenter of the current crisis.

Scott Grannis said...

Mark: Interesting suggestion. My data on housing is limited to the OFHEO series which only goes back to 1978. Comparing that to gold I see that housing was cheapest relative to gold in 1980, then it peaked at the end of 2000, then fell by half to today's level. Housing has gotten relatively cheap compared to gold in recent years because gold has risen while housing prices have been falling. Other measures of affordability say the same thing: housing is once again affordable and getting cheaper by the day.

SpeakToMe said...

Looking at those charts, its easy to imagine oil going back beyond $150. The peak last year was a long time in the making, and it seems most reasonably explained as an unrolling of Peak Oil. This year's sudden drop, on the other hand, looks like it might be most usefully explained as a financial deleveraging as all of the oil players unwound at once.

Scott Grannis said...

Speak: financial deleveraging undoubtedly played a role in the collapse of oil and most other commodities. But you have to give some credit also to the economic slowdown and to what must have been a huge increase in the world's ability to produce these commodities--which in turn was a function of the dramatic price increases in recent years. Prices could well increase again in the future, but not quickly.