And Gas Will Cost $5 per Gallon in the Next 36 to 48 Months Given The Fed Once Again Likely to Journey Down the Road of Quantitative

An article in the Wall Street Journal on Wednesday notes the falling value of the U.S. Dollar based on the expectations that the Fed will once again resume purchases of securities from banks. So what are the implications of the Fed actions and why did the U.S. Dollar fall in value?

The central bank of a country (which in the U.S. is the Federal Reserve Bank–known as the Fed) can stimulate an economy by making interest rates decline and thus making it cheaper for business to borrow funds and expand capacity and less costly for consumers to borrow money to buy goods and services, both of which ultimately will result in job growth and economic recovery. But what can the central bank do when rates are already close to zero? And in the U.S. we are pretty much there. On October 5, 2010, the 1-Year Treasury bond yield was 0.25 percent (1/4 of 1 percent per year) and the 2-Year Treasury note at annual yield of 0.41 percent (yep—not even ½ percent per year). [By the way, I would not tie-up my money at such low yields for these terms due to the imminent increases in interest rates. This topic will be another Blog entry soon.]

Another monetary tool to stimulate the economy is to increase the money supply, making money (and credit) more readily available. The central bank accomplishes this by buying securities (government and corporate bonds, and mortgage-backed securities) from banks which in turn provides the bank increased reserves allowing them to create money (quantitative easing) which will hopefully increase economic activity. This action reduces the banks investments (Treasurys, Corporates, MBSs) and increases the bank reserves on hand. The impact, however, is like watering down of the value of the currency (just as adding water to a great tasting soup waters it down and makes it less desirable). So goes the watered down soup, so goes the watered down currency.

An immediate impact of a weakened U.S. Dollar is the increased cost to import goods and services. As the U.S. Dollar declines, imported goods and services cost U.S. consumers more. One of the largest imports is oil as we import 60 to 70+ percent of the oil consumed in the U.S. each day. In 2009 (which was a down year on total imports due to a weakened economy) we saw an average 11.7 million barrels per day of oil imported into the U.S. http://apps1.eere.energy.gov/news/news_detail.cfm/news_id=15772 Total cost of imported oil in 2009 exceeded $263 billion or approximately 17 percent of total imported goods and services.

There exists a very strong inverse relationship between oil prices and the value of the dollar since 2002 as shown in the following graph. Oil is expressed in August 2010 dollars, as adjusted by the CPI index excluding energy. The exchange rate is the number o f U.S. Dollars required to purchase a € Euro. As the value of the U.S. Dollar declines (and the red line rises), oil prices increase. The Pearson Product Moment Correlation Coefficient between the exchange rate and oil prices is 0.822 (with a p-value of less than 0.01), while the non-parametric Spearman’s Rank Correlation Coefficient is 0.797 (also with a p-value of less than 0.01). Thus, so goes the value of the dollar, so goes—in the opposite direction—the price of oil. In analytical terms, the relationship is statistically significant at the 99 percent level of confidence.

Compounding the impact of a declining value of the U.S. Dollar is the amount of Federal government borrowing required to fund the massive deficit. Ongoing borrowing will weaken the U.S. Dollar further, driving oil prices even higher yet. Be sure and read the blog entry on Sept 14th showing why interest rates will rise due to the declining value of the U.S. Dollar.

We now have set the stage for rising interest rates, rising oil prices, and therefore rising gasoline prices. Throw in some economic recovery in the next 18 to 30 months (increasing the demand and price for oil) and you have my forecast: Gasoline will cost $5 per gallon sometime in the next 36 to 48 months—and that will hurt the economy.
At the same time, however, from a real estate perspective, properties closer to where people work and shop will become more valuable as transportation costs escalate (and for those cities with mass transit in place, properties near mass-transit access will also become even more valuable). If I am correct on all of this (and there are a lot of items being juggled in the air in this analysis), location of property becomes even yet key in the near future.

As far as the forecast of $5 gasoline, I hope I am wrong. But if you agree that the forecast might be correct, then you too can hedge yourself by purchasing stock in oil and gas exploration and production companies and refineries.

Tags: exchange rates • Home value • interest rates • Oil prices