Be Careful of Reading Too Much into Price Changes

Article excerpt

SUPPLY AND demand. When it comes to economics, you don't get much more fundamental than this. We know what they are. But we are a long way from knowing how to measure them. Those of you who have ploughed through your economics textbooks will have fond memories of demand and supply schedules and will remember that the equilibrium price of anything - pork bellies, cinema tickets, workers - would be found at the intersection of supply and demand. The problem, though, begins when the price changes. The price goes up. Demand has risen? Perhaps, but maybe supply has fallen. The textbooks could show you all the reasons for why prices might move. They were less helpful in telling you why, on any particular occasion, a given price would either rise or fall.

Here lies the problem. Much of what we think we know about the economic world comes from price movements. Yet price movements are, by their very nature, ambiguous. When prices change, we are forced to come up with a hypothesis - no matter how vague - for why the price change is occurring. The most obvious example is commodity prices. They are typically very volatile and people often see them as a lead indicator of broader economic activity. When commodity prices go up, people become more optimistic about economic growth because they see rising commodity prices as a sign that demand has gone up. But the oil price shocks of 1973 and 1979 can hardly be seen in the same way. Undoubtedly, commodity prices were higher but only because of a sudden restriction in supply.

What relevance does all this have for today? The simple answer is that markets have been subject to some extraordinary price moves over the past few months. Yet these price movements mean different things to different people. It's back to supply and demand. What's driving these price movements and how should policy makers react?

Oil prices are a good starting point. Before the war in Iraq, it seemed obvious to most people that a short conflict would lead to much lower oil prices. For the Western world, this would undoubtedly be a "good thing" - lower oil prices were the equivalent of a free tax cut, lowering costs to companies, leading to a terms of trade improvement for industrialised economies as a whole and, hence, kick- starting economic recovery. It's not surprising that everyone thought this; as my left-hand chart shows, the 1991 Gulf War led to a dramatic decline in oil prices that undoubtedly contributed to the end of recession - if not the beginning of decent recovery - in 1991 and beyond.

Not this time, though. Oil prices fell back a bit after the Americans took Baghdad but they're still very high. A $30 barrel was not what President George Bush had in mind when he was carrying out his cost-benefit analysis of an attack on Saddam Hussein. So how should we view this? A generous interpretation would simply be to say that the global economy is recovering nicely. With the war out of the way and business confidence heading upwards, the implied increase in global demand could quite reasonably be a catalyst for higher oil prices.

To my mind, though, this doesn't quite ring true. Oil prices today are more or less as high as they were in 1999 and 2000, at the peak of the global economic boom. On any measure, there is a lot more spare capacity sloshing around the global economy today than there was then. It would be reasonable, therefore, to think that oil prices should be a bit lower. That they're not suggests that other factors are at work. The US thought it could impose its will on the Middle East and, to date, it has failed. That failure could, in itself, justify higher oil prices. As a result, an oil price "peace dividend" has simply not materialised. …