In a recent Wall Street Journal “Investing” column, Heather Gillers and Sam Goldfarb (GG) report a seeming paradox: Interest rates (on Treasury bonds) are rising sharply “despite a decline in oil prices, a key driver of bond yields since the start of the war in Iran.”
That premise is problematic: Standard economic analysis predicts that an increase in interest rates should engender a decline in crude oil prices, other factors held constant. Notice that the simple long run (1987-2025) correlation between annual average yields on 10-year Treasury bonds and annual average prices for West Texas Intermediate crude oil is -0.70, meaning that a one-unit change in one is associated with a 0.7-unit change in the other in the opposite direction. For 30-year Treasury bonds and WTI prices, the simple correlation also is -0.70.
Correlation is not causation; many factors affect interest rates and the price of crude oil. But the negative correlation between the two is driven by the fact that the consumption of crude oil is “intertemporally substitutable,” that is, a barrel can be produced and consumed during the current time period or in a future one. Market forces determine the allocation of such resources over time.
Consider that choice confronting an oil producer between production of a barrel of crude oil this year versus next year. Suppose that the market rate of interest is, say, 7 percent, and that the market expectation of a future supply disruption increases such that the expected price of crude oil between now and next year rises by 10 percent. The oil producer can sell an additional barrel of oil today, put the sales proceeds in the bank, and earn 7 percent. Or the producer can leave that barrel in the ground, planning to sell it next year, and in effect expect to earn 10 percent.
The obvious choice is less production now and more planned for later. Of course, all producers confront that same choice, so that the market supply of crude oil this year contracts, yielding higher prices now, while the expected market supply of crude oil in a year increases, resulting in a market expectation of future prices lower than initially predicted. Accordingly, the equilibrium market expectation — other factors held constant — no longer is a 10 percent increase in crude prices over the ensuing year. Instead, higher prices now and an expectation of lower prices next year result in an expected price path that rises at the market rate of interest, 7 percent in our example. In short, it is no paradox that an increase in the market rate of interest should result in a short-term decline in the price of crude oil, again holding other factors constant. For any given expected future price of crude oil — say, $100 per barrel a year from now — an increase in interest rates from, say, 7 percent to 8 percent means that the current price of oil has to fall in order to grow by 8 percent to $100 in a year.
By arguing that interest rates are rising “despite a decline in oil prices,” GG seem to be adopting the premise that a decline in oil prices should yield a decrease in inflation expectations, and thus a decline in interest rates. The common assumption that increases in oil prices are “inflationary” is not correct. Inflation is a continuing rise in the general price level such that the purchasing power of a unit of currency — a dollar — declines on an ongoing basis. Inflation is always and everywhere a monetary phenomenon, caused by growth in the nominal supply of money greater than growth in the real demand to hold money (or greater than the growth in output).
A change in oil prices is a change in relative prices: If oil prices increase, the prices of goods and services produced with substantial oil inputs will rise as well. The prices of substitutes for oil and those goods and services also will tend to rise. The prices of goods the demand for which is complementary with oil — say, large conventional trucks — will tend to fall. Because a change in relative prices induces a shift of resources across sectors — a market economic adjustment that takes time — increases in oil prices are recessionary, other factors held constant, rather than inflationary.
The GG argument that interest rates are rising “despite a decline in oil prices, a key driver of bond yields since the start of the war in Iran” ignores the reality that the war has had the effect of increasing oil prices and uncertainty about international security conditions. That latter impact explains why interest rates have increased in the context of the war. But the more fundamental principle remains valid: Because of the economics of natural resources the consumption of which is intertemporally substitutable, crude oil prices fall when interest rates rise. Other factors held constant.
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