Thursday, June 30, 2011

Exchange Rates and Oil Prices*

US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. Empirically, there is clearly an inverse correlation between oil prices and exchange rates – that is, other things being equal, oil prices rise if the dollar falls. An assessment of the dynamic conditional correlation (DCC) and of the one-year rolling average correlation between the daily change in the oil price and the daily change in the nominal effective exchange rate shows that this relationship has been relatively strong in recent years, although the negative correlation has been declining in recent months. What is less clear, though, is the direction of causality. Several econometric techniques suggest that causality may run from the oil price to the exchange rate, rather than the opposite.

This finding supports the traditional terms of trade argument on the relationship between exchange rates and oil prices. Terms of trade effects suggest that when the price of an import rises, if the demand for that import is very inelastic, (i.e. quantities demanded hardly fall at all when the price is increased, as is the case for oil) this produces a deterioration in the trade balance, which will decrease the value of the local currency.

However, the relationship between the price of oil and the exchange rate might be much more complex than the initial terms of trade impacts would suggest. Reverse causation, i.e. exchange rates influencing oil prices, is possible. Several transmission mechanisms could underpin such reverse causation. First, since oil is denominated in US dollars, a weaker dollar might lead to an increase in the demand for oil in non-dollar economies, which would cause the oil price to rise. Second, if oil producing countries have a target export revenue in their currencies to finance their government budget deficit, then with a weaker dollar they might reduce the supply of oil in order to drive up the price to achieve their targeted export revenue. Third, investors would likely increase their demand for commodities as a hedge against inflation when the dollar falls. This might put upward pressure on the price of oil. However, there is limited, if any, empirical evidence supporting these effects.

Apart from reverse causation, it is further argued that both the exchange rate and oil prices might be reacting to some other common factor. One such factor might be monetary policy. Since oil is a storable commodity, it reacts not only to current but also expected future monetary policy. Likewise, the exchange rate is also determined by current and expected monetary policy. Therefore, we should expect to see both oil prices and exchange rates as jointly determined.

The interactions between the exchange rate and oil prices are more complex than traditional economic theory predicts. However, those believing in strong reverse causation from exchange rates to oil prices are effectively acknowledging the likelihood of a self-perpetuating cycle in which a weaker dollar drives crude higher which in turn sends the dollar even lower. The lack of clear evidence for such a spiral, so far, along with our own econometric findings, suggests that the more likely causation runs from oil prices to the exchange rate instead.

*IEA Medium Term Oil and Gas Markets-June 2011

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