James Pethokoukis

Politics and policy from inside Washington

Oil prices, inflation and a double-dip recession

October 26, 2009

Andy Xie paints a dire scenario:

Central banks around the world have released massive amounts of money in response to the current financial crisis … But the proposition that a weak economy means low inflation is false. The stagflation of the 1970s proves it.

This round of monetary growth has mainly fed speculation, not credit demand for consumption or investment. Speculation has reached a dangerous point with the oil price threatening to reach triple digits again. Its implications for inflation may spook the central banks to raise interest rates quickly and trigger another crash.The excess money supply has created a new liquidity bubble.

The resulting asset inflation (stocks and bonds in developed markets and everything in emerging markets) has stabilised the global economy. The current equilibrium is one on a pinhead. The hope for strong economic recovery led by emerging economies raises investor optimism – and asset prices. This eases pressure on corporate balance sheets, spurs property production and boosts consumption through the wealth effect, making the hope self-fulfilling in the short term.

A rising oil price threatens to derail this recovery. It can trigger a surge in inflation expectation and a major crash of bond markets. The resulting high bond yields may force the central banks to raise interest rates to cool inflation fears. Another major downturn in asset prices would reignite fears about the balance sheets of global financial institutions, leading to new chaos.

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