Let’s start with a simpler question. What is the significance of OPEC’s control of oil prices?
Imagine that OPEC produces 40% of the world’s oil. Cartel also has a lot of excess capacity. Let us now consider its control of global oil prices.
As oil demand and non-OPEC oil supply are relatively inflexible in the short term, OPEC has the ability to double global oil prices, or cut it in half overnight. This is a lot of control. Therefore, let us assume that OPEC will set the global oil price at US$100 per barrel and adjust the output so that prices stay firm.
There is a problem with this policy: In the long run, oil supply and demand become more flexible. So now let us assume that the oil price of 100 US dollars led to the fracturing revolution, and non-OPEC supply has increased sharply. In order to keep the price at $100/barrel, OPEC must reduce production to 35% of global production, then reduce it to 30% and then reduce it to 25%. It can be done for a while, but it is painful.
OPEC is also worried about the long-term viability of the oil market, so it is no longer wise to finally decide to keep the price at $100, although technically it can continue to do so until its output falls to zero. It is in the long-term interest of the Organization of Petroleum Exporting Countries to face the reality and allow oil prices to rise to lower oil prices. There are two ways to achieve this
OPEC can stop controlling oil prices. It can instruct its members to produce a total of 40 million barrels a day and let the market determine prices.
2. It can continue to control prices, but it can gradually reduce prices as needed to keep daily production close to 40 million barrels (as fracturing production increases). Therefore, it may drop the price to US$95 in a few months, then fall to US$90, and fall to US$85 in the next 3 months. The price will drop to a few steps and eventually reach $45 in a few years. At each step of the process, prices will be set at a level that is expected to maintain stable OPEC production, but once new prices are reached, production will be adjusted daily as needed to maintain price stability. Then a few months later, the price is reduced by another 5 dollars.
Therefore, in the case of #1, OPEC does not control global oil prices, if the situation #2 OPEC controls oil prices. But these two conditions are actually very similar, and as the price adjustments get smaller, the two conditions become more similar. Therefore, you can imagine that the price adjusts one dollar at a time instead of five dollars, and that adjustments occur more frequently.
Have you changed from OPEC’s control of global oil prices to the market’s control of global oil prices?
Let us now review the fracturing boom described above. It is assumed that the Organization of the Petroleum Exporting Countries actually used a step-function method of price reduction to respond to the fracturing boom, as described in Case #2. Therefore, in a matter of months, the price will be determined by OPEC, and then suddenly drop by 5 US dollars/barrel. How do you see this multi-year price drop from $100 to $45? Is it even more meaningful to talk about the fracturing climate that has led to a sharp drop in oil prices? Or if we say that OPEC caused a sharp drop in oil prices?
On the one hand, you may think that OPEC controls the price of oil during this period, and thus caused a decline. It regularly adjusts official prices and has always been able to put world prices in different positions.
On the other hand, the fracturing boom is a huge destructive force in the global market. With the rapid growth in oil production, it has caused global prices to fall. OPEC can offset at least some time, but it chose not to keep OPEC production close to 40 million barrels per day. The Organization of Petroleum Exporting Countries did not take concrete measures to support oil prices.
Since terms like “cause” are not clearly defined, there is no correct answer. But in this case, I think I prefer to say that the fracturing economy has caused the oil price to plummet. I don’t think this is just me; many economic experts will think this is a description of what caused the price of oil to fall sharply.
Facts have proved that this example is strikingly similar to the slump in interest rates from July 2007 to May 2008. Before reviewing this example, recall one important aspect of the previous example. I said that in the short-term, OPEC may continue to maintain oil prices at more than 100 US dollars in a longer period of time, but it also has long-term goals to consider, which makes OPEC conclude that it is wise to let prices fall, so it The long-term holding of the oil market will not be completely lost.
Now think about the Fed from 2007 to 2008. The real estate industry is falling drastically, and mortgage loans are much less. The decline in credit demand has brought downward pressure on interest rates. In order to prevent the Fed from cutting interest rates, it must continue to reduce its monetary base. This tight currency keeps interest rates below 5.25% (through liquidity effects).
However, the Fed is aware that if it does a measure to prevent falling interest rates, then this policy will disrupt its long-term economic goals. important moment! Therefore, instead of reducing the monetary base, it decided to allow interest rates to fall while maintaining basic stability. There are two ways to do this:
1. It can remain basically stable at 855.5 billion U.S. dollars (floating 1%) and completely stop the target interest rate. Let the market determine the interest rate.
2. It can instruct the New York Fed to reduce interest rates by 1⁄4% or 1⁄2% every few months to keep the base stable. In the days when the official Fed fund targets have not been adjusted, the New York Fed will keep interest rates stable, and the base will be adjusted slightly and fluctuate.
You can also imagine some intermediate situations, such as the official federal funds rate target will be adjusted in steps of 5 basis points instead of the 25-point step. The smaller the adjustment, the more the market seems to set the exchange rate level as a stable monetary base.
I think Case #1 and Case #2 are actually very similar. But in the case of #1, the market seems to be setting interest rates, and in the case of #2, it looks like the Fed is controlling interest rates.
Let us now return to the weak credit market triggered by the housing slump. Is it even more meaningful to talk about the weak credit market suppressing interest rates? Or should we say that the Fed’s interest rate fell in 2007-08? If it is the latter, how did the Federal Reserve lead to a drop in interest rates? After all, the Federal Reserve has not increased its monetary base. This is the usual way of causing a fall in interest rates. (This is pre-IOR).
The opinions will be different, but I think it is more useful to talk about a weak credit market that causes the interest rate to fall, and the Fed adjusts its official target because the “natural interest rate” fell during the 2007-08 period. However, since the Fed always has the technical ability to remove the real interest rate from the natural interest rate, at least for some time, others will tend to say that the Fed has caused the interest rate to fall. I will not strongly oppose this statement. Despite this, it is interesting that, although other authorities will agree with my views on the fracturing boom, they may disagree here and insist that the Fed will cut interest rates.
What I strongly object to is the argument that the Federal Reserve has caused interest rate declines in 2007-08 through loose monetary policy. I disregard anyone’s suggestion of a coherent simplified currency, which means that funds will be easy in 2007-08 (when the nominal interest rate falls), and it will be easy in the second half of 2008 (when real interest rates soar). During the hyperinflation of Argentina in the 1980s (when the base was soaring) was strained.
I recently gave a speech at Kenyon College. This article (along with another EconLog article) was a motive for discussion with Will Luther. He instructed me to see an early article of him:
I am very happy to see David Henderson calling out Bill Poole claiming that the Federal Reserve set the federal funds rate. of course not. Welcome to Wicksell Club, David! We don’t have a tie or T-shirt. But our common cause is worth it.
When I insisted that they mentioned setting the target of the federal funds rate (rather than setting the federal funds rate), many of my economists were irritated. They know that the Fed does not really set the federal funds rate, which is determined by the suppliers and demanders of the overnight market; and, as Bernanke has clearly pointed out, the Fed even has a limited impact on short-term interest rates. However, they believe that this is a convenient and short result.
I disagree. Maybe I spent too much time in the liberal arts environment, but I believe the language we use is very important. In this case, the dominant language of the Federal Reserve interest rate can easily assume that the federal funds rate is low, because the Fed’s goal is very low. Because of the low market settlement federal funds rate, it is even difficult to consider the possibility of a low Fed target. In addition, this shows that the Fed is in a direct and dominant position. In fact, the Fed plays an indirect role. At least according to my assessment, it is subordinate to the daily market forces. It also seems to continue the common mistake of linking low interest rates with expansionary monetary policy and high interest rates and tighter monetary policy.