Recently, an interesting article in the Washington Times discussed a direct relationship between gold and oil prices. Although historically there have been periods when this was true, there are many periods since 1986 when the movement of these prices diverged. Here is the statistical relationship found by the author of the article:
ADVERTISING"Downloading daily gold and West Texas oil price data from readily available sources, one can perform a calculation to estimate the price of oil based on the price of gold. For example, if the price of gold for the given day is $326.30, multiply that number by .0602 ounces of gold to get a value of $19.643 per barrel...On a sample of daily interval data from January 2, 1986 to March 3, 2012 (6,457 matching intervals), using basic statistics, a 2-sample t test was performed and the results are eye-opening.
We can say that .0602 ounces of gold times the price of gold produces the price of a barrel of oil, with an standard error of just .421%, or an average difference of just $6.10 dollars between the calculated price and the actual price since 1986. For the last 26 years, the price of gold dictated the price of oil with 99.579 percent accuracy."
However, Figure 1 illustrates the natural log of both prices for an ounce of gold and a barrel of oil since 1986.
Figure 1: Gold and Oil Price Relationship
Source: Fed FRED
Since these are in logs, the change between two periods is the percentage change. Therefore, one data point below the period before will indicate a negative percentage change and vice-versa. If no other market fundamentals affected these prices except for the value of the dollar, considering that both commodities are priced in dollars, then these two should increase and decrease together. As you can see, there are periods when these two commodities move closely together and other times when they do not.
The data indicate there is a relationship between the two, but there are many times when this link is not as strong. Since the prices of gold and oil are measured in dollars and in the long run, however long that may be, they should revert to an average relationship. The article notes this relationship to be ".0602 ounces of gold times the price of gold produces the price of a barrel of oil".
Using this simple calculation with the price of gold closing at $1,607 per ounce this past Friday, then multiply this price by .0602 provides an oil price of $96.74 per barrel. However, oil closed at $91.39 per barrel on Friday. This $5.35 difference between the projected and actual oil price indicates that there are other market fundamentals at work.
Economic research indicates that the fundamentals of supply and demand in the oil market are important to understand for short run and long run fluctuations. In particular, these fundamental changes allow more pricing information for which endeavors are profitable and which ones are not. Moreover, the primary source of oil price fluctuations from oil supply, oil demand, or precautionary oil demand can lead to significantly different economic effects.
In my research, I find that a global demand for oil shock, represented by a real global economic activity measure that reflects global demand for commodities that is dominated by crude oil, has significantly greater economic effects than disturbances specific to the oil price. A global demand for oil shock is the major contributor to oil price fluctuations since the 1970s and has a larger impact on the unemployment rate, real GDP growth, and the inflation rate in the U.S. compared with a shock to the price of oil.
How bad is the current state of the economy? According to University Chicago Economist John Cochrane, it is scary bad!
Although he uses a less technical critique in his recent post on The Grumpy Economist, I agree with his general prognosis and suggest that you read it. The economy is growing too slowly compared with previous economic expansions and the trend of key economic indicators are dismal. The "gaps" that emerge from these indicators, such as real gross domestic product (See Figure 1), and their historical trends or "potential" are shocking.
Figure 1: The Output Gap Remains Larger Than Any Other Period Since WWII
Source: Fed FRED
These indicators and others do not paint a bright picture of the current state or the future of economic prosperity in America. In particular, Friday's employment report should indicate that the labor market remains weak. Specifically, I look for the employment-to-population ratio — my favorite labor market indicator — to remain at 58.6%, which is substantially lower than the 63% before 2008 (See Figure 2).
Figure 2: Labor Market Remains Weak
Source: Fed FRED
Although some of this decline is from Baby Boomers retiring — approximately 10,000 per day — this does not explain the persistently lower employment-to-population ratio. The establishment survey may report that 100,000 net jobs were created in July and an unemployment rate of (still) 8.2%. The unemployment rate is a weak signal, at best, because it does not count individuals who are underemployed or who are so discouraged, they are no longer looking for work during this "recovery"; thus, weakness in the labor market is underreported.
The Federal Reserve indicated Wednesday that some form of QE3 — a third round of monetary easing via asset purchases such as Treasury bonds — is brewing. Some argue that the Fed should set a rule to target the path of nominal GDP, which would try to boost aggregate demand in the economy by consumers because inflation expectations should rise and create a "buy now" phenomenon. Will this action by the Fed boost goods, services, commodities, and stock prices enough to increase inflation and inflation expectations to lower real interest rates and generate aggregate demand to boost the economy? Even if this is possible and it gives an appearance of a rule-abiding Fed, what underlying distortions does this create throughout production processes?
With little evidence indicating positive results from the Fed's previous unconventional monetary policy actions since the Great Recession began, it seems to me that more purchases of mortgage-backed securities or long-term Treasuries will do little to get the economy back on track. Purchasing more mortgage-backed securities would be the worst option because record low mortgage rates already exist, and the housing market is not booming. What is another few tenths of a percentage point lower going to achieve? Purchasing long-term Treasuries is a relatively better option, but the Fed has purchased between 60-70% of newly issued long-term debt instruments by the Treasury over the last year with little economic improvement.
Despite the calls for nominal GDP targeting, higher inflation will likely be the endgame, which would reduce the real value of private and public debt. This is an appealing result for some, such as Economist Paul Krugman; but even if inflation does not pick up and real debt values do not decline, real economic growth will be unlikely to occur from this approach. To put it bluntly, the supply side of the economy is in horrible shape, and fading fast, from numerous discretionary policies by the Fed and Congress and should be the primary concern.
At the end of the day, relative to our current Fed system and assuming its existence, I would rather see the Fed have a money growth rate rule, which economist Milton Friedman advocated, an individual mandate of price stability, and retain its original purpose of "lender of last resort." Instead, the Fed abuses discretionary monetary policies, puts too much emphasis on their other mandate of maintaining full employment, and lends as a first resort in too many cases.
The more we ask from politicians and economists in policy making roles without the ability of full knowledge, the more we will be let down. I suppose that this conclusion from an aspiring macroeconomist may signal that I have little left to achieve, but I have a very different perspective of macro compared with the mainstream of maximizing a representative agent's utility function. I would like to hear your thoughts.
Vance Ginn, Ph.D.