Deflation and Oil Prices: Should Investors Worry?

AMA2-18-15Oil prices are falling, dropping below $200 USD for a barrel of crude. And while that makes US consumers happy, the tumble in prices is fueling worries of a looming round of deflation that could ripple throughout the economy and trigger another round of intervention by the Federal Reserve.

Because petroleum products play an enormous part in the economy as a whole, the ups and downs of the oil industry affects just about all major sectors. In areas where Big Oil has a high profile, jobs, housing and local retail and manufacturing are buoyed – or potentially sunk – by the boom and bust cycle of worldwide oil supply and demand. That’s why the recent fall in oil prices has economists and financial experts concerned about the possibility of a “deflationary spiral” that could eventually require another round of government intervention.

For consumers, the major concern is inflation – higher prices, and a dollar that doesn’t go as far as it used to. But the consequences of deflation may actually be greater. The “deflationary spiral” that financial experts fear begins with a drop in prices, as we now see with oil.

But although that drop should mean that people buy more, they may not, choosing to wait instead for even lower prices to come along. If that happens, there’s an excess in the production of various commodities. To move that inventory along, prices drop even more. But if consumers still aren’t buying, the cycle continues to perpetuate itself, spiraling down and down.

A healthy consumer economy is driven by the willingness of people to buy things. And if that doesn’t happen, the whole structure is weakened. Consumers delay spending, and debtors have a harder time securing debt. And because energy is a linchpin of that structure, the drop in oil prices could signal the beginning of a deflationary spiral and threaten another recession.

When a sluggish economy threatens recession, it may be time for government intervention in the form of quantitative easing, as the Central Bank artificially manipulates interest rates and the flow of money to keep major sectors moving. That’s what happened during the troubled years following the housing collapse of 2008 when the Federal Reserve instituted not one, but three rounds of easing. The last of these, dubbed QE3, involved the buying up of $85 billion in mortgage-backed securities every month to keep interest rates low and encourage buying.

As the economy began to stabilize after the housing crash, the Feds began a gradual taper off of the stimulus in 2014. But now, some economists worry that deflation triggered by the drop in oil prices could mean another round of easing to prop things up. But according to a recent report from Business Insider, the current drop in oil prices may actually make that kind of intervention less likely – and it may not even lead to the usual consequences of deflation. In fact, the opposite may be true.

As Business Insider points out, lower oil prices benefit consumers, who will pay less for gas and heat. Lower gas costs free up household income for buying things or paying down debt. As people buy more gas, the government is able to collect more in taxes and tariffs on those transactions. While the “deflationary spiral” paradigm depends on consumers’ reluctance to buy, even when faced with dropping prices, in reality, spending less for gas probably means people will be spending what they’ve saved in other ways.

Lower oil price alone aren’t likely to cause problems for central banks, unless prices in other major sectors also start to drop. Low oil prices help to keep inflation down, and because consumers can buy more and pay down debt, the two major consequences of inflation – a slowdown in buying and problems with covering debt – probably won’t happen, except in certain areas of the country where the drop affects the performance of local oil producers.

In those areas where oil production is a major contributor to the local economy, a slowdown could mean a drop in housing prices and loss of unemployment as well as the decline of local businesses. But in those areas where oil is sonly one of many enterprises in a diverse economic picture, those effects are likely to have little impact. (Top image:Flickr/cliftonsteed)

Source:

Udland, Myles. “Three Reasons Why Lower Oil Prices Won’t Lead to a ‘Deflationary Spiral,.” Business Insider. businesinsider.com 1 Feb 2014.Insider. businesinsider.com 1 Feb 2014

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The American Monetary Association Team

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