[nero]

It is conventional wisdom around here that interest rates will go up because inflation will go up and that inflation will go up because of the increase in oil prices. I'm not arguing this but I would like it if someone would check out the following reasoning.

Interest rates are fundamentally set by the demand and supply of savings. When the savings rate increases and all else is held constant the interest rate goes down as the marginal extra dollar saved goes after worse and worse investments. Conversely when the demand for investment increases the interest rate goes up.

Peak Oil will cause an enormous spike in the energy prices. This increase in energy prices will suddenly make alot of energy projects that were previously uneconomic very very attractive. People and companies will recognise these opportunities (even if they don't understand peak oil) and will bid up the demand for savings as they try to attract the investment to exploit these new opportunities.

Therefore not only will interest rates be increased by ignorant central bankers who try to control an inflation ultimately caused by the depletion of a non-renewable resource, they will also rise due to the inherent investment opportunites created by those same rising oil prices.

The one great problem with this theory is that it doesn't conform with the historical data. The past 4 years has seen a huge increase in energy prices yet it was also a time of incredibly low interest rates. Where am I going wrong in my logic?

[smallpoxgirl]

I spent a while today staring at this graph. It's from the DOE report on oil shale (http://www.fe.doe.gov/programs/reserves ... ancev1.pdf). From the looks of it, with where oil prices are right now, our economy should be in the crapper. We should be looking at 15% interest and %15 inflation. I don't quite understand why we aren't.

[trespam]

$this->bbcode_second_pass_quote('smallpoxgirl', '
') We should be looking at 15% interest and %15 inflation. I don't quite understand why we aren't.

[nero]

How does asset deflation cause low interest rates?

I can see:

asset deflation leads to lower perceived wealth
lower perceived wealth leads to higher savings (to compensate)
higher savings means reduced consumption
reduced consumption means less demand for savings
higher savings less demand for savings means lower interest rates

is there another mechanism?

[trespam]

$this->bbcode_second_pass_quote('nero', 'H')ow does asset deflation cause low interest rates?


is there another mechanism?

[Bytesmiths]

$this->bbcode_second_pass_quote('nero', 'W')hen the savings rate increases and all else is held constant the interest rate goes down as the marginal extra dollar saved goes after worse and worse investments. Conversely when the demand for investment increases the interest rate goes up.

[nero]

$this->bbcode_second_pass_quote('', 'T')his seems contradictory to me. Savings is a form of investment. Why do you separate the two, and how to you discriminate?

[nero]

$this->bbcode_second_pass_quote('', 'B')ut if someone takes money out of their bank savings accounts and puts it into a mutual fund, it's still savings, but it's non-debt investment, and it doesn't compete with other borrowing, and interest rates go down.

[MonteQuest]

Stay on topic guys. Tie the discussion to peak oil depletion or the thread goes to the open forum. The parameters for posting on this forum have tightened.

Thanks!

MQ

[ozkrenske]

I think that what is currently happening is to all intents and purposes 'off the charts', Trying to use historical data to correlate trends when the proverbial paradigm shift has occurred is very difficult.

Now to tie it back as Monte has requested.

The oil depletion/peak is so unwanted that there are many forms of denial currently being practised. But and this is a big but many are starting to confirm in their own and corporate minds that it is happening as such we get 2-3 reactions.

Locking in supplies, signing long term contracts at above current prices, I believe a lot of this is happening right now and what it is going to do is reduce the 18-36 month flexibility of the oil markets effectively forcing up the spot prices because a large fraction of the oil production is already locked. I recently moved towards this on a personal level, purchasing 2000 litres of fuel for redemption in the future. I paid 5 cents a litre over bowser but the short term outlook of the depot, will pay off for me in the future.

Companies that will see major effects from transport price hikes, like Walmart (cheap shipping all over the country and cheap consumer transport to the cheap blocks the retail outlets are on will vanish and as such they will suffer when transport costs go up) and other cheap energy liking companies and industries will see share drops. Canny investors/insiders will drop them before the market as a whole catches on, apparently some of this sort of thing is already happening.

Other companies are going to need cheap capital to rapidly develop alternatives. This will require either under priced loans to them or keeping interest rates down.

I also believe that rising oil prices will actualy replace the use of interest rates in reducing consumer spending power and so help to reduce inflation in the future.

So the long term will see Oil price rises forcing the stock market down ( a pusher for lower interest rates ) the reduced wealth will see reduced spending ( a further push for lower interest rates ) and a rapid attempt to develop alternatives needing cheap capital ( another low interest rate factor). I think in the 5-10 year time period we should see long term interest rates remain low because of these factors, probably not as low as now but still historically low.

Now what will become the principle factor on inflation, that is simple, it will be the higher energy and transport costs. Inflation rates have more or less been pushed by the consumer demand side for generations, (fed of course by cheap energy) so that for a lot of that time we have seen the use of high interest rates to keep the inflation rate down on the supply side. But in the near future, demand side will stop being the cause, rather supply scarcity of oil/energy will become the cause of inflation and the cure there is actually lower interest rates to help the development of alternatives or increased production.

Of course if a government or it's agency(the fed) remains stuck in it's ways and panics slamming up interest rates in a panic response to higher inflation (caused by supply weaknesses rather than unnecessary demand) then those rate increases will hurt the economy even more. Many people in the US have serious economic limitations on their ability to reduce consumption in any short period. The demand is in many ways very inelastic.

[nero]

I try to remove the central banker from my understanding of interest rates. If he single mindedly manages short term interest rates to avoid inflation then he shouldn't really factor into the equation. One should be able to talk in theoretical terms about the equilibrium demand for capital. One problem though is that the central banker has a very poor idea what the equilibrium demand for capital is.

(keeping Monte Happy)

In terms of oil this causes a problem because if there is a huge change in the capital requirements of the energy sector (due to attempts at solving depletion), this may translate into an increase in the equilibrium interest rate. If the central banker doesn't recognise this phenomenom there is the potential that he will attempt to keep short term interest rates too low leading to inflation. On the other hand if he raises interest rates in response to the higher energy prices causing inflation, he has to recognise that some of the inflation is inherent (because of the greater cost of extracting energy from the ground) and that he can't ring 100% of the inflation out of the system without causing demand destruction.

I think these changes in the structure of the economy may make it harder for the central banker to perform his job as we go forward towards peak oil. Greenspan has received many compliments for his skillful handling in the past decade, but his successor may have a much harder environment to work in even under the most optimistic scenario where with enough investment we can transition to fossil substitutes for light sweet crude.

[MonteQuest]

Another factor to consider is that we may have to raise interest rates to attract the capital to finance our deficit spending and our trade imbalance. I see the old nemesis, stagflation making a return. In the 1970s, a 5 percent imbalance between supply and demand created shortfalls of liquids, gasoline, and long lines at the pump. At that time, high price was less of a worry than availability of fuel. Such a loss, even though a small percentage of total needs, was enough to adversely affect the flow of goods and the mobility of people, with severe consequences to the U.S. economy. The period of the 1970s represents a model, at least for the early stages of a supply shortfall. If peak production occurs unexpectedly, the United States will likely experience all of the negative effects seen in the 1970s.

$this->bbcode_second_pass_quote('', '"')The 1973 Arab oil embargo created a massive price rise and economic dislocation, from Tokyo to Paris to Chicago. The explosion in oil prices ushered in a decade of "stagflation" in which inflation soared while economies stagnated. By the end of the decade, the United States experienced double-digit unemployment, double-digit inflation and double-digit interest rates."

[MonteQuest]

Here is a lot of answers, guys:

The effects of the recent oil price shock
on the U.S. and global economy
Nouriel Roubini, Stern School of Business, NYU
and Brad Setser, Research Associate, Global Economic Governance
Programme, University College, Oxford
This Draft : August 20042
http://www.stern.nyu.edu/globalmacro/Oi ... Setser.pdf

[nero]

$this->bbcode_second_pass_quote('MonteQuest', 'H')ere is a lot of answers, guys:

[ozkrenske]

Nero,
I am indeed starting to see some rude reality breaking into economic discussion with people realizing that non renewable resources are actually going to run out or skyrocket in prices.

I cornered a group of economics lecturers ( I work at a University ) on Wednesday at lunch and asked them to answer my question of what exactly would the last 50% of oil on earth be worth, given that demand would always be higher than production and that at current rates of consumption equaling production the remainder would always be at full capacity. Two said in such a situation prices would rise continuously unless suitable alternatives could fill production gaps for oil needs, the other one said that while he agreed with the others, 'the world is years away' from such a situation. 'Luckily' I had a oil industry geologist stop by the table after half an hour only minutes after the above statement and state effectively my scenario was actually where we are right now. It was quite interesting watching the reactions of the Economics guys to that.

I fear that Economics based on pure markets without physical limits being applied to the ideas that they run on will see central bankers (who have lifetimes of experience of having no real shortfalls or limitations) make some serious mistakes. The faster they realise that Rising oil prices (and thus transport and production costs and then prices) will not be stopped by high interest rates and that the world will need cheap credit to switch energy systems and adapt the better. Of course that sucks for the ability of the US and other dollars to maintain strength without interest rate hold up's but I believe there will be some serious currency drops very soon anyway.

Amazingly here in Aus the Federal treasurer has publically asked people to limit spending after spending years suggesting people should keep the economy ticking thru spending. I think he is starting to read the warning signs that people are about to be hammered by interest rate increases and he is trying to soften the effects.

[spot5050]

Hi nero, sorry but your post falls down at paragraph two;

$this->bbcode_second_pass_quote('nero', 'I')nterest rates are fundamentally set by the demand and supply of savings. When the savings rate increases and all else is held constant the interest rate goes down as the marginal extra dollar saved goes after worse and worse investments. Conversely when the demand for investment increases the interest rate goes up.

[nero]

$this->bbcode_second_pass_quote('spot5050', 'N')o, central banks set interest rates - at a level that they feel will manage inflation within their sphere of infuence.

[MrBill]

$this->bbcode_second_pass_quote('nero', 'I')t is conventional wisdom around here that interest rates will go up because inflation will go up and that inflation will go up because of the increase in oil prices. I'm not arguing this but I would like it if someone would check out the following reasoning.

Interest rates are fundamentally set by the demand and supply of savings. When the savings rate increases and all else is held constant the interest rate goes down as the marginal extra dollar saved goes after worse and worse investments. Conversely when the demand for investment increases the interest rate goes up.

Peak Oil will cause an enormous spike in the energy prices. This increase in energy prices will suddenly make alot of energy projects that were previously uneconomic very very attractive. People and companies will recognise these opportunities (even if they don't understand peak oil) and will bid up the demand for savings as they try to attract the investment to exploit these new opportunities.

Therefore not only will interest rates be increased by ignorant central bankers who try to control an inflation ultimately caused by the depletion of a non-renewable resource, they will also rise due to the inherent investment opportunites created by those same rising oil prices.

The one great problem with this theory is that it doesn't conform with the historical data. The past 4 years has seen a huge increase in energy prices yet it was also a time of incredibly low interest rates. Where am I going wrong in my logic?

[cube]

$this->bbcode_second_pass_quote('MrBill', '.')..
Basically, inflation is caused by money supply growth, not higher prices.
...

[cube]

$this->bbcode_second_pass_quote('spot5050', '')$this->bbcode_second_pass_quote('nero', 'I')nterest rates are fundamentally set by the demand and supply of savings.