Although movements in the value of the dollar are one factor contributing to recent changes in the dollar price of oil, I do not believe they are the most important factor. Here I review some of the evidence that persuades me of this.
There are a variety of reasons why oil prices and the exchange rate might move together. A drop in U.S. interest rates relative to Europe was likely one factor that contributed to both the increase in the price of oil and the increase in the value of the euro earlier this year. Over the last few weeks, expectations of weaker European output helped the dollar to gain against the euro and also brought oil prices down. Yet another example, and the one people often think of first, would be if there is a higher inflation rate in the U.S. than Europe. In that case we might expect to see an increase in the price of oil that exactly equals (in percentage terms) the decrease in the value of the dollar.
In all of the above examples, depreciation of the dollar is associated with an increase in the dollar price of oil. But it is also possible for the relation to go in the opposite direction. For example, strong economic growth in the U.S. would cause the dollar to appreciate as the price of oil increased.
The graph below plots the cumulative logarithmic change since 1999 in the dollar price of one euro along with the dollar price of one barrel of oil. If the inflation effect were all that was going on these data, we would expect to see the two series track each other closely. The dollar has depreciated by 30% over this period while the price of oil today is 10 times what it was in 1999. Obviously something other than the pure inflation effect has been involved.
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Because the nature of the news impacting both exchange rates and the price of oil has been different at different points in time, I was curious to explore the correlation between oil prices and exchange rates using a rolling regression. For any day t, I calculated the change in the natural logarithm of the price of oil over the last 5 business days, and regressed it on a constant and the change in the natural log of the dollar/euro exchange rate over same 5 days. To get a sense of how the relation has changed over time, on any day t I estimated this relation using only the most recent 200 business days, so that for each day between October 1999 and August 2008 I obtained a different coefficient estimate relating the price of oil to the value of the dollar. The graph below plots those estimated regression coefficients for each day, along with 95% confidence intervals. [Note for the wonks: the latter were based on Newey-West standard errors with lag length 10, made necessary because the overlapping nature of 5-day intervals introduces serial correlation in the regression residuals].
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In the early part of the sample, the correlation was actually negative– days when the dollar appreciated tended to be days when the price of oil rose. As Menzie has noted, for the sample as a whole the correlation between the two variables is not statistically significant. Since 2003, however, the correlation has almost always been positive (the dollar depreciating on days when oil prices went up) and often suggests a coefficient near 1.0, consistent with the inflation story. As of the most recent 200 days, the estimated coefficient had risen all the way to 1.76– a 1% decline in the dollar is associated with almost a 2% increase in the price of oil– and that coefficient is statistically significantly greater than one. To explain a coefficient bigger than one, something more than the simple inflation effect would have to be at work.
Another way to gauge how important this relation might be is to look at its out-of-sample forecasting performance. Here I calculated the answer to the following question. Suppose you could know today what the actual change in the exchange rate over the next 5 days was going to be, and you used the regression coefficients estimated over the previous 200 days to predict what the change in the oil price over the next 5 days would be, given the future exchange rate. How big an error would you make in trying to “predict” the price of oil if you already knew what the exchange rate would be? I looked at the average squared value of a forecast error constructed in this way over the most recent 200 days (each forecast using different regression coefficients as estimated from a different previous sample), and divided it by the average squared change in realized oil prices over the last 200 days. One minus this magnitude corresponds to an out-of-sample uncentered R-squared, which again can be calculated for each day between August 2000 and August 2008. This number measures the fraction of the variance of oil price changes that could be explained by the exchange rate according to the most recently estimated regression, and is plotted below.
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Over much of the sample, this R-squared is actually negative, meaning one would have had a better forecast if one had simply predicted that the price of oil would not change next week as opposed to predicting that it would move in the direction and by the magnitude implied by the most recent regression of the oil price on the exchange rate. On the other hand, in the most recent data the relation appears to be statistically useful. Recently, 20% of the variance of oil prices could be accounted for by news that also mattered for the dollar/euro exchange rate.
Between January 1, 2007 and July 14, 2008, the dollar depreciated by 18%. If we take that most recent coefficient estimate of 1.76, the regression above would have predicted a logarithmic increase in the price of oil of 31%, or a move from $61/barrel in January 2007 to $83 in July. In fact, oil peaked at $145 on July 14. Since, then, the dollar has appreciated by 5.9%, while the price of oil has fallen by 23%.
The exchange rate is unquestionably one variable that influences the dollar price of oil. In recent data, as much as 20% of oil price movements could be attributed to changes in the exchange rate, or at least to news developments that matter for both exchange rates and oil prices. But that also means that 80% of what we see happening to the price of oil is completely uncorrelated with whatever might be influencing the exchange rate.
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Nice post, Professor Hamilton. Do you suppose the analysis would change in any significant way if you used oil price expectations derived from options prices?
Or, as the US policy causes the dollar to weaken, the Europeans weaken their own currency to compensate?
As unconvinced pointed out, other currencies are being inflated along with the dollar because the dollar is most other central bank’s reserve currency. Every other major country is undergoing inflation right now.
Try measuring the us dollar in items that aren’t as easy to inflate, like oil.
Is the Dollar’s Value the Most Important Contributor to the Price of Oil?
James Hamilton submits: Although movements in the value of the dollar are one factor contributing to recent changes in the dollar price of oil, I do not believe they are the most important factor. Here I review some of the evidence that persuades me of th
Professor Hamilton, I forgot to also ask how much influence does the real oil price have upon the real euro-dollar exchange rate? Thanks.
There is no doubt that there is a supply disruption premium attached to the price of oil. A few week ago the spot price jumped on the news of Israel’s dress rehearsal for a strike on Iran. In the last few weeks it has become apparent that the US is less inclined to strike Iran and is in restraining Israel… hence the price drop.
Try comparing charts of oil vs. Swiss Francs and Swiss Francs vs. USD over the last 10 years to get a truer picture of the trend in oil price and the devaluation of the buck.
Broxburnboy, I agree with your first sentence. As for the Swiss franc, do you mean (correctly) that the Swiss franc is even more of a safe haven currency than the euro or the yen carry trade? In other words, the Swiss franc is even significantly more likely to move inversely with international equity markets and risk perception.
Prof. Hamilton’s analysis suffers from the common problem of measuring the value of the dollar against other inflating currencies. Two posters had it correct, but failed suggest a better measure. Try gold. Gold is the most monetary of commodities and only reflect the value of the dollar not the unchanging value of gold. I would agree that dollar weakness is not the only factor, but it is the significant factor. Measuring the dolalr depreciation against a depreciating euro masks the significance. John Tamny has it spot (pardon the pun) on: “The oil discussion has for the most part centered on supply, but the simple truth is that since June of 2001 oil has risen 160 percent in euros versus over 380 percent in dollars.”
Charlie, if you mean replace the left-hand variable (the change in oil price) with the change in expected oil price, I would expect the results to be very similar, since changes in the spot price are the dominant factor in changes in futures or option prices. If you mean replace it with the expected change in oil price, I would expect the results might be quite different.
I have not attempted your calculation with the real exchange rate, but it might be interesting.
Satish, I don’t really understand why you think of this as a “problem” with what I did. I was simply asking the question, What is the statistical relation between the nominal dollar/euro exchange rate and the nominal price of oil? I believe I answered this question correctly. You evidently want me to ask a different question. Well, there are lots of different questions out there. We’ve talked at great length here at Econbrowser about the many other factors influencing both oil prices and exchange rates, as well as the advantages and disadvantages of various approaches to measuring inflation. But we don’t talk about all these issues in every post, and this one was about the connection between the nominal exchange rate and the nominal price of oil.
European demand will react less than US demand for a given oil price increase for two reasons. One, the strong Euro means the price increases to Europeans is not as large. Second, because taxes account for a larger share of gas prices in Europe a given percent change in crude prices generates a smaller percent change in European gas prices than in the US.
But unless you are going to posit that the weak dollar leads to increased speculation in favor of higher oil prices from dollar holders this implies that the strong Euro would tend to support higher oil prices, but the direct impact would be relatively minor.
JDH, you are correct that if you were only to address the correlation between the nominal dollar/euro rate and oil, your post is illuminative and does answer the question. But I would kindly quote the beginning of your piece which makes a (much) broader claim: “Although movements in the value of the dollar are one factor contributing to recent changes in the dollar price of oil, I do not believe they are the most important factor.” I take this to mean that you believe that the nominal euro dollar rate is something akin to the value of the dollar. If you were to strike this first sentence I would strike my post. Sorry if I came off as less than generous in my comment.
Professor,
In addition to comparing dollar v oil/dollar v euro why not compare dollar v gold? If you define inflation as the relatonship between the dollar v the euro, yes, the price of oil can be confusing, but because the euro and the dollar are floating, neither are stable enough to be used as a firm base.
This can be seen when oil, euro, and dollar are compared to gold. You can see great inflation in the dollar, less inflation in the euro while oil tracks with the dollar/gold inflation not the euro/gold; oil is price in dollars after all. This will give a clearer indication of the inflation component.
Thank you, Satish. I see that my wording was broader than I intended, hence inviting some of these responses.
The reason I wrote the post is that I have been struck recently by the apparent comovement between the dollar price of oil and the dollar/euro exchange rate, and wanted to take a formal look at how much there was to it.
A recent Dallas Fed Economic Letter suggests that the dollar accounts for roughly one-third of the price increase.
http://www.dallasfed.org/research/eclett/2008/el0805.pdf
Thomas,
Thanks for the link. It appears that the Dallas FED paper makes the same questionable assumption between the euro and the dollar that JDH made.
The Dallas FED paper states that from 2003 to 2007 oil went from around $40 bbl to $100 bbl or a 150% increase. They also state that about 25% of this is inflation when measured as dollar/euro. But over the same period the dollar price of gold increased from around $360 to $780 or about 130% (Of course this depends on the period used. The numbers could be even closer.) Clearly the gold relationship indicates that much more of the oil price increase was due to inflation of the dollar. Using a dollar/euro comparison under reports inflation because it ignores inflation of the euro.
R-squared is negative? Are they using imaginary correlations in econ these days? I’m going to need to go back to school.
US’s Current Account Adjustment Redux: What’s Different this Time Around?
Menzie Chinn submits: The dollar is on the rebound against the euro [0], [1]. The non-oil trade deficit is shrinking as a share of GDP [2]. Is this a replay of the 1980’s adjustment process? Read more »
Ken, the in-sample centered R-squared for a univariate regression that includes a constant term is indeed the square of the sample correlation coefficient– hence the name. It can be calculated as one minus the ratio of two sums of squares, which ratio, for a regression that includes a constant term, is between 0 and 1 by construction. One can talk about exactly the same statistic (one minus that ratio) even if the regression does not include a constant term. Since it is exactly the same statistic, it is given the same name (R-squared) even though it no longer is the square of the correlation and indeed that number can now be negative. One minus an out-of-sample ratio of these sums of squares, which is the magnitude used in this post, can also be referred to as an out-of-sample R-squared, though again there is no reason the statistic has to be nonnegative, and indeed here at times it is negative.
So you see, you don’t need to go back to school. You just need to read Econbrowser!
Charlie: Prof. Hamilton’s analysis suffers from the common problem of measuring the value of the dollar against other inflating currencies. Two posters had it correct, but failed suggest a better measure. Try gold. Gold is the most monetary of commodities and only reflect the value of the dollar not the unchanging value of gold.
Charlie is correct to point out that Hamilton has committed the egregious error of comparing a relative monetary price (exchange rate) to an absolute one (the dollar price of oil), and has guessed wisely that a comparison between two absolute dollar prices, especially between oil and gold, is far more revealing.
I have appropriately tweaked Hamilton and compared gold and oil here. Between 2000 and 2008, using weekly quotes, the correlation coefficient between the dollar prices of oil and gold is 0.93. For this and other reasons, I conclude that the dramatic runup in oil prices between 2000 and 2008 is mostly due to monetary rather than fundamental factors. Many of these factors have effected Fed and ECB behavior similarly, thus the much lower correlation in most periods with the dollar/euro exchange rate.
My article also addresses a number of other fallacious claims that have been put forth in an attempt to rebut the monetary explanation.
Errata: the material I quoted should be attributed to satish instead of Charlie.
Nick, there is no error whatsover, let alone an egregious one, in comparing two variables. The data are what they are, and I report the facts.
Maybe your theory says there should be no connection between A and B, but if a researcher looks at the data to find whether there is or is not a relation, you can hardly accuse the person of making an “egregious error.”
Perhaps you think you find an error in the conclusion I draw from such a comparison. It appears you’re making up a conclusion for me to have supposedly drawn, and then puffing yourself up to criticize that straw man.
JDH, your general error lies in at least strongly suggesting, and in seeming to still believe, that this is a useful comparison for concluding what you seem to still want your readers to conclude, that the dollar has played less of a role than fundamentals in determining the dollar price of oil. Here is a specific and very egregious error in your analysis that reflects this general problem:
…if there is a higher inflation rate in the U.S. than Europe. In that case we might expect to see an increase in the price of oil that exactly equals (in percentage terms) the decrease in the value of the dollar.
You then go on to use the euro/dollar exchange rate as a proxy for “the value of the dollar.” This is preposterously wrong. If there is surprise inflation of 1% in the euro and surprise inflation of 2% in the dollar, ceterus paribus we should see a 2% rise in the dollar price of oil and a 1% rise in the euro against the dollar. If it’s 2% surprise inflation for the euro and 1% for the dollar we should see a 1% fall of the euro against the dollar and a 1% rise in the dollar price of oil. The same goes (but exponentially) for changes in inflation expectations. A rise in the dollar price of oil need not be at all be correlated with the euro/dollar exchange rate for dollar inflation to have caused that rise.
This flawed analysis is used to try to demonstrate your original thesis:
Although movements in the value of the dollar are one factor contributing to recent changes in the dollar price of oil, I do not believe they are the most important factor.
By “movements in the value of the dollar” you seem to mean merely the euro/dollar exchange rate, but your vague phrasing leads the highly misleading impression that this exchange rate is the same as the actual, i.e. absolute, value of the dollar, and leaves the impression that your data allow one to reach a conclusion ruling out the value of the dollar as the main component of the dollar price of oil. It does no such thing. It would do so if the euro were some magically stable standard of value against which to compare the variable dollar, but it is not, it is a fiat (to use the term used by Hayek, Friedman, Greenspan, etc.) and floating currency just like the dollar.
You then conclude with the following:
In recent data, as much as 20% of oil price movements could be attributed to changes in the exchange rate, or at least to news developments that matter for both exchange rates and oil prices. But that also means that 80% of what we see happening to the price of oil is completely uncorrelated with whatever might be influencing the exchange rate.
Generally all monetary factors influence the exchange rate, but often and probably usually in ways that largely cancel each other out in the exchange rate. In other words a wide variety of factors, including similarities in economic theories, statistics, growth, and forecasts used by the Fed and ECB, and similarities in government finances, credit crunches, and so on can influence the Fed and ECB to act in very similar ways. These all can be said to be influences on the dollar/euro exchange rate, and thus readers could conclude from your last statement that you believe your analysis to have ruled out all but at most 20% of the oil price movement as being due to monetary factors. Your analysis in no way eliminates these monetary factors, and you need to seriously edit your post in order to avoid leaving this highly misleading implication.
Also, since despite your extremely misleading conclusion you now suggest that you are only “reporting” “the facts”, I issue this challenge:
if you think that we can conclude anything useful at all about the relationship between monetary factors and oil prices from this comparison of yours, please tell us in unambiguous language what you think it is that we can conclude. (There are some useful things that can be concluded, but I don’t think you know what they are).
I would also love to hear you attempt to explain why there is a 0.93 correlation coefficient between gold and oil prices between 2000 and 2008.
Nick, the only thing preposterously wrong here is what you maintain that I believe. Your game seems to be to make up an outlandish position that you pretend someone to be “strongly suggesting,” and then point out that the position is outlandish.
If it is possible for the two of us to communicate with each other (which I doubt it is), the necessary first step would be for you to assume that if something is preposterous or outlandish, then it’s probably not what I was “strongly suggesting.”
I for my part assume that my readers are pretty bright.
So, for example, you should start with the (entirely correct) premise that I would never for a minute entertain the “highly misleading impression that this exchange rate is the same as the actual, i.e. absolute, value of the dollar”. And that when I spoke of the “value of the dollar” in this post, I was referring exactly and specifically to the exchange rate. I had apparently been mistakenly assuming that readers understood this.
Nick, while I agree with most of your argument, you do know what type II spurious regression is right?
when I spoke of the “value of the dollar” in this post, I was referring exactly and specifically to the exchange rate
You declared this private meaning of yours nowhere in your post, and it is extremely misleading to covertly substitute your own private meanings for public ones. Even more misleading when the meaning you have attributed to exchange rates is dead wrong — no floating exchange rate reflects a privileged “the value” of the dollar as if the currency it was being traded against was a fixed standard. You have simply made an egregious error on this point, an error that destroys the utility you implied could be derived from your analysis, and have refused to admit it.
Using ordinary economic and English definitions, rather than your cryptic and confused code, normal readers will quite reasonably translate “Although movements in the value of the dollar are one factor contributing to recent changes in the dollar price of oil, I do not believe they are the most important factor. Here I review some of the evidence that persuades me of this.” to “I do not believe the dollar is the most important factor. Here I review some of the evidence that persuades me of this.” The latter conclusion as I have shown cannot at all be derived from your analysis, and the former can be so derived only when its meaning is translated using your ex post (post post? 🙂 private code in which “the value of the dollar” really just means the euro/dollar exchange rate.
Even your use of “the exchange rate” is an invitation for confusion. You specifically used the euro/dollar exchange rate, and if you want to be clear rather than confused in your language and your thoughts you should stick with the well defined “euro/dollar exchange rate” rather than vague phrases like “the exchange rate” or the utterly misleading “the value of the dollar.”
You appear to have originally made the confused translation leading to the invalid conclusion yourself as suggested by your final sentence
But that also means that 80% of what we see happening to the price of oil is completely uncorrelated with whatever might be influencing the exchange rate.
which I showed above cannot at all be derived from your analysis. Monetary factors can influence the euro/dollar exchange rate in offsetting ways and be strongly correlated to the oil price. Your analysis in no way eliminates these monetary factors. I look forward to you coming up with another creatively obscure and confused definition in order to render this last sentence meaningless or trivial instead of false.
Paul, are you suggesting that somebody has accepted a false relation based on spurious regression?
Nick, what is the “public” meaning of the “value of the dollar”? In what units is this value commonly understood to be measured and reported? Is it the value of a dollar in terms of how many fish a dollar can buy? Is it the value of a dollar in terms of how much oil a dollar can buy?
This post uses “value of the dollar” to refer to how many euros a dollar can buy. That apparently now comes as a surprise to you. But to allege that it was some private secret that I had been discussing the dollar/euro exchange rate, when every graph and every equation uses precisely this number, is beyond ridiculous.
Nor is “uncorrelated” a private or secret term, nor is it a meaningless or trivial expression. “Uncorrelated” has a formal statistical definition. The final sentence of the post is making a precise and refutable mathematical claim about the data.
The idea of using another fiat currency to measure the devaluation of the dollar seems flawed. Indeed, if you use other currencies or gold (or any other commodity for that matter) you get dramatically different results. While I agree that there are other factors which affect the price of oil in dollars, I think your conclusion that only 20% of the rise in oil prices is due to currency devaluation is unrealistically low. In a world with so many different currencies to choose from, why did you choose the euro? It can’t be because they are our largest trading partner because that would be Canada. It can’t be because they are among the largest oil producers because that isn’t true either. So why not choose the Swiss Franc as someone else suggested? It is the only currency that I know of that is at least partially backed by gold. Or why not gold, the oldest currency on the planet? Why not the Australian $? Or Canadian $?
Frankly, I think the vast majority of the rise in oil prices is due to the currency devaluation. We aren’t running out of oil and while there have been increases in demand, it seems to me that those demand increases have been met with adequate supply. Are there shortages somewhere of which I’m unaware?
And frankly, sir, your tone in responding to Nick is uncivil. You ask what is the public meaning of the value of the dollar and seem to imply that the answer to that question is obvious and that it is the value in euros. Well, I live in Miami and I can tell you that the public meaning of the value of the dollar here is probably different from yours. And it might very well be a better idea to measure the value of the dollar in the amount of fish it would buy. At least fish have a real value. I believe your intention to use the euro was obvious and you are right that it wasn’t some secret, but it seems to me that if you are truly curious about the answer to your question, you should consider using other proxies for the value of the dollar. Picking one currency, simply because it is how you view the value of the dollar, cannot possibly provide a definitive answer.
http://www.realclearmarkets.com/articles/2008/08/a_strong_dollar_will_reduce_oi.html
I just saw your response to Satish about the broad wording. While I wish I had seen that before I wrote my last comment, I think our comments are valid and would like to see you expand on your analysis to include other proxies for dollar value. Your analysis for the euro is of course correct, but I think fails to answer the original question. Now that you’ve invited these responses, maybe you could respond with a broader analysis.
Joe Calhoun says
Yet another reader telling me what I “seem to imply” and then being indignant about it. No Joe, what I intended you to conclude from my words is exactly the opposite of the inference you reached. What I thought my examples of fish, oil, and euros would clearly help the reader to see is that there is no obvious “public meaning of the value of the dollar”. My question, “In what units is this value commonly understood to be measured and reported”, was meant to be instructive. The reader is intended to reflect, “gee, I guess there aren’t any units that we all would assume this is measured in.”
No, I do not believe at all that the public meaning of the value of the dollar should be obvious. But what I thought should have been obvious to everyone, but evidently is still not to you, even though I have repeated it many times in the comments here, is that my post is about the relation between the nominal dollar/euro exchange rate and the nominal price of oil. I remain completely perplexed by readers who insist that I must have been talking about something else , refuse to believe me when I say I was not, and then attack me for something I did not say!
If I wanted to write about how to measure inflation, then I would have written about how to measure inflation.
This discussion seems to have moved from how to determine what is the real price of oil to how to determine what is the real value of a US dollar.
Money in the US is created from debt. Each USD is simply a promise to pay from a debtor whose is given credit from a US bank who in turn borrows from the Federal Reserve and ultimately, as recent guarantees have shown.. from the US taxpayer.
The trend in the value of the dollar then will reflect the ability of the creditor to repay … determined by the number of IOUs (dollars) in circulation and the perceived creditworthiness of the borrower (US gov’t). As the number of dollars in circulation increase without a perceived matching increase in the ability to repay, the purchasing power of the USD, in barrels of oil or barrels of fish, will decrease. In recent years the ability to repay has been negatively affected by skyrocketing public debt, massive deficits in trade and current accounts, the destruction of personal savings and the disappearance of home equity.
These increases in commodity prices need not be in lockstep, as each commodity has its own “political” and economic fundamentals which influence supply and demand and perceived supply and demand of future prices.
In this environment we can draw general trends but it is nigh impossible to correlate the value of the USD to any one particular commodity or currency. I believe that current temporary optimism (misplaced) regarding the resurgence of the US economy and the ability of the US taxpayer to repay is responsible for the current strength of the US buck and weakness in oil price. Perhaps this optimism reflects the belief that the credit crunch is over and that public deficits are under control.
JDH now writes:
Yet another reader telling me what I “seem to imply” and then being indignant about it…If I wanted to write about how to measure inflation, then I would have written about how to measure inflation.
But in the blog post you didn’t merely imply that you were trying to test the inflation hypothesis for the oil price rise, you outright said you were trying to test it:
If the inflation effect were all that was going on these data, we would expect to see the two series [dollar-euro exchange rate and dollar oil price] track each other closely.
Judging from your dismissal of satish’s, my, and Calhoun’s objections as irrelevant, you apparently have had a big change of mind about the relevance of your analysis to inflation since making your original post, but have forgotten all about what you said there. I recommend that you re-read your original post to recall what you wrote and then update it to reflect your new understanding. If you aren’t willing to do that, you shouldn’t wonder that people keep criticizing its obvious flaws. They are responding to what you actually said, not to some secret opinions you may now harbor in your mind.
OTOH if you have not changed your mind, pray please tell us by what reasoning you arrived at this whopper:
If the inflation effect were all that was going on these data, we would expect to see the two series [dollar-euro exchange rate and oil price] track each other closely.
I and several other commenters have repeatedly demonstrated that this is quite false.
Nick, I have had no change of mind. You have simply misinterpreted me from the beginning. It’s that simple.