Why Gas Prices Rise as the Dollar Falls

 Here's one of those complex economic truisms the financial press assumes everybody understands: A big reason oil and gas prices are hitting record highs is that the dollar is hitting record lows. Got it? The world's petroprinces evidently do. The limp dollar has prompted a bickerfest between President Bush, who's been urging the OPEC oil nations to produce more oil so prices will fall, and OPEC leaders, who say the problem isn't limited production but the weak dollar and economic woes in the United States.

Makes perfect sense—as long as you have a Ph.D. in economics. For those who don't, I asked Kristin Forbes, a professor at MIT's Sloan School of Management and former member of the White House's Council of Economic Advisers, to help explain how exchange rates affect gas prices:

Let's discuss why the dollar is so low in the first place.
Economists have been predicting for years that this was likely to happen, and now it is happening. As the U.S. economy has been weakening, interest rates have been falling, and when interest rates fall, investors want to hold less of that currency, because they can get a higher return someplace else.

Basically, that's simple supply and demand, isn't it?
The price of the dollar is falling, in terms of the amount of other currencies it takes to buy one dollar. So you're paying less in euros, for instance, to get one dollar.

So in that equation, the price of the dollar is the same as the value, and as the value falls, there's less demand for it?
Yes. But a bigger reason for the falling dollar is that the United States is running a massive current account deficit, which we're funding by borrowing from the rest of the world. We've been able to borrow at low rates, but that can't go on forever. A falling dollar is an automatic adjustment mechanism, which means there's an increase in exports from the United States and lower imports into the country, which helps rebalance the deficit.

And now that we're in an economic downturn, or maybe even a recession, what does that have to do with it?
When you have weaker economic growth, the Fed usually lowers interest rates—one of the things that lowers the value of the dollar.

So how does a falling dollar contribute to rising oil prices?
It's a little bit complicated. Oil is priced in dollars on the world market. When the dollar is weaker, foreign currencies are stronger, by definition. That means people in other countries can buy more oil for the same amount of money. So let's assume oil is $100 per barrel, and $100 is equal to 70 euros. If the euro appreciates against the dollar by 10 percent, then instead of 70 euros it will take only 63 euros to buy one barrel of oil. So that oil becomes cheaper to foreigners, and they can buy more.

And do they buy more?
Usually, yes. There are other factors obviously, like in many countries taxes are such a big portion of the cost of oil that the savings aren't that dramatic. But it would still make sense to buy more if the price in your own currency goes down.

So for those of us stuck with the dollar, why does that make the price of oil or gasoline go up?
As people in other countries buy more, demand rises, and it drives up the price in dollars, which, again, is how the price of oil is denominated on world markets. So in the United States it looks like the price is going up sharply, in dollars, while in other countries it's actually going up by much less or staying about the same.

Which other countries, and currencies, are most important in this equation?
Certainly the euro, the Canadian dollar, and some of the Asian currencies, such as the Chinese yuan and the Japanese yen, although the Asian currencies have strengthened less against the dollar.

There's another whole effect we're starting to see recently. As people become more worried about inflation, they're investing more in commodities in general, including oil. And that also drives up demand and prices.

So concern about inflation is indirectly driving up the cost of oil, which in turn is contributing to inflation?
Seems ironic, but yes. Although I doubt that this is as important as other factors driving up the price of oil—such as strong growth in parts of the world such as China and India.

Another important issue is that in a lot of countries, like India, China, Indonesia, and some Arab countries, the price of oil and gasoline is subsidized, to keep the domestic price low, usually to prevent social unrest. That matters because if oil prices were allowed to be set at market prices, demand would fall, and so would prices. So demand in those places is artificially high.

So do you think oil prices will stay where they are? Or are they artificially high and likely to fall?
I think oil prices are distorted on the high side. If they stay high, new supply will come onto the market.

Because it makes sense to increase supply if you can sell it at a high price?
Right. And if prices stay high for long, we'll start to see oil companies begin to extract some of the higher-cost oil, like from the oil sands in Canada. More supply will reduce the price.

What about the U.S. economic slowdown? Isn't that supposed to reduce demand a bit, and theoretically lower prices?
It depends on whether we see increased demand for oil in other countries. The big question is whether the slowing of U.S. growth spills over into other countries or whether those countries continue to grow rapidly and demand more oil.

The decoupling question.

What's your best guess about whether we're going to experience a recession?
I think it's a close call whether we're technically in a recession. The second quarter may be tough, but I think by the third and fourth quarter we're going to bounce back. We'll be feeling the effects of the huge fiscal stimulus and the interest rate cuts by then.

You mean new cuts the Fed may yet make? Or cuts the Fed has already made?
Cuts the Fed has already made, which usually take six to nine months before they fully impact the economy.







March 10, 2008 11:21 AM ET | Rick Newman