Since the beginning of 2004, benchmark crude oil prices have more than doubled. However, the U.S. economy continues to grow at about 4%. From June 2004 through August of this year, the Federal Reserve boosted the federal funds target rate 10 times. But long-term interest rates were lower than they were in early 2004. Is this all some vast mystery, or is there actually some connection?
In the rush to embrace expectations as the explanation for all economic events during the past two decades, the relationships among loanable funds, saving and investment got tossed to the wolves. Well, fundamentals still count for something. And once we abandon our dependence on expectations and return to underlying factors of demand and supply, the decline in long-term interest rates since early 2004 -- and, hence, the continued improvement of the U.S. economy -- turns out not to be such a mystery.
There has been a huge increase in saving that dwarfs the rise in investment, both in the U.S. and on a worldwide basis. And the main ingredient has been the rise in oil prices. Previously when oil prices rose, investment in the energy patch also rose. Not so this time. The increase in saving that has occurred as income has been transferred from oil users to oil producers, but this increase has not been offset by higher investment. What kinds of numbers am I talking about? Since early 2004, oil prices have more than doubled, rising from $35 per barrel to more than $65 per barrel. The world produces about 27 billion barrels per year, so what we are seeing is an annual rate of increase in world saving of about $810 billion. Investment in energy on a worldwide basis, on the other hand, has increased by less than $100 billion.
The lack of investment in the energy patch has probably occurred because most oil producers do not expect high prices to last very long. The memories of the mid-1980s, when oil prices suddenly crashed from $35 per barrel to $12 per barrel before recovering a little, are still fresh in the minds of many investors in Texas and other oil-producing states. Even Saudi Arabia, which at one point literally could not figure out how to spend all of its newfound oil revenues, was close to financial collapse after oil prices plummeted. This time around, producers are being much more cautious and not rushing to find new sources of petroleum.
What has happened to that huge increase in saving? Very little has gone into purchases of physical plant and equipment. Some has been directed into the housing market, which has indeed been a contributing factor to rising real estate prices. Less has gone into the stock market. Recent gains are certainly anemic compared with those of the 1990s. Most of the huge increase in saving has gone into debt securities, including but not limited to Treasury securities, with the net result that long-term interest rates have declined. And to the extent that interest rates are a determinant of the core rate of inflation, it too has remained stable, in spite of rapid growth and the declining value of the U.S. dollar in 2003 and 2004.
Higher oil prices are certainly not bullish for the U.S. economy. But to the extent they are offset by lower interest rates -- and are accompanied by rising housing prices -- they do not reduce real growth either. By the same token, a decline in oil prices is likely to be accompanied by rising interest rates and sluggish housing prices. And when that occurs, growth will be slower.
Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.
