Wednesday, April 25, 2012

Do Exchange Rates Matter?*

Oil prices have experienced large fluctuations in recent years.  The spike in crude oil prices in mid-2008 to more than $140/bbl, followed by a steep correction in late 2008/early 2009 and subsequent sharp rebound over the last two years have jolted the world economy and pinched consumers at the fuel pump. US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. However, this explanation is challenged by the empirical observations that (a) a change in oil price tends to lead to a change in the exchange rate as predicted by economic theory and (b) the oil price has risen regardless of what currency unit one uses to measure the price of oil.

Empirically, there is clearly an inverse correlation between oil prices and exchange rates – that is, other things being equal, oil prices rise if the dollar falls. An assessment of the one-year rolling average correlation between the daily change in the oil price and the daily change in the nominal effective exchange rate shows that this relationship has been relatively strong in recent years, although the negative correlation has been declining in recent months. As we suggested in our Medium-Term Oil and Gas Markets 2011 report, however, the direction of causality tends to run from oil prices to exchange rate, especially when we use lower frequency observations. This is consistent with the traditional terms of trade argument on the relationship between exchange rates and oil prices. Terms of trade effects suggest that when the price of an import rises, if the demand for that import is very inelastic, (i.e. quantities demanded hardly fall at all when prices rise, as is the case for oil) the trade balance deteriorates, which would decrease the value of the local currency.

The price of oil in different currencies provides further support to the notion that weakness in the US Dollar cannot be the main reason behind the high oil prices. The relationship between the change in oil price and change in the exchange rate is considered to be country-specific. For oil-exporting countries, when oil prices go up, ceteris paribus, we expect the country’s exchange rate to appreciate. On the other hand, for oil importing countries, the reverse should hold.

For example, as expected, our analysis shows that the correlation between annual change in the oil price and annual change in the Canadian exchange rate is very strong. The price of Brent crude oil measured in US Dollars increased by more than 11% in the first quarter of 2012, from $111/bbl to $123/bbl. During the same period, the Canadian Dollar appreciated by 1% relative to the US Dollar. In the meantime, the price of oil measured in Canadian Dollars, as expected, increased only by 10%. Since the rate of currency appreciation is much smaller than the rate of oil price increase, we observed an increase in the oil price in Canadian Dollars as well.

The price of oil measured in different national currencies has followed very similar directional movement with oil prices measured in US Dollars, although some of these currencies appreciated against the US Dollar. The main reason for this, as suggested by Martin Feldstein, is that “the currency in which oil is priced would have no significant or sustained effect on the price of oil when translated into dollars, euros, yen, or any other currency.” The equilibrium price in the oil market is determined by global supply and demand; it is irrelevant which currency oil is priced in. The decline of the US Dollar has little to offer as an explanation to the increase in oil prices. On the other hand, the high and rising price of oil does, contribute to the decline of the dollar through the terms of trade effect.


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