Gasoline, politics, and the dollar

We have long argued that the Bush administration has been happy with a lower dollar as a weaker dollar should be seen as a means to an end and that end is greater employment growth.

It all seems so one way - the lower dollar together with fiscal and interest rate policy would all combine to stimulate the economy in this election year 2004. In the 'politicisation of the dollar' we argued that the administration would be happy with a lower dollar as long as it served their interests.

We went on to argue that by July all the easing should be in place and in the system and a period of stability in the dollar over the election period would be in their best interests.

Here we demonstrate how the lower dollar may be starting to become an election issue much sooner than we first thought. Recently there has been a big political brouhaha regarding gasoline prices. In level terms gasoline prices are at a record high, and it has been recently reported that they have reached a national average of $1.80 a gallon.

Although on the more authoritative database shown in the chart above it is below that level, that should not detract from the overall upward trend and the fact that they are at historically high levels. The Democrats are attempting to make political capital out of the rise in gasoline prices and at this stage Kerry is calling for the government to stop pumping oil into its emergency stockpile.

In addition, Kerry's campaign aides are also stressing that the Democratic candidate wants the U.S. to pressure OPEC to increase production and apply diplomatic pressure to the member nations to reduce prices. However, we would take a different approach - we would argue that a large part of the rise in crude oil price is related to the declining dollar and the rise in gasoline prices is only following crude oil up.

The real price of gasoline (gasoline prices relative to the CPI) obviously tracks crude oil prices. In the US the tax take on gasoline is low by western standards and hence tracks the crude price quite closely. The chart above shows that both real gasoline and nominal crude prices have risen sharply since early 2002, the time at which the dollar started its descent. The connection between the US dollar and oil price is simple.

Oil is priced in dollars and producers do not want their real purchasing power of a barrel of oil eroded by a fall in the value of the dollar. In order to do this, they need to raise the price per barrel as the dollar falls. This would then mean their real purchasing power of goods and services around the world for a barrel of oil remains unchanged regardless of the movements in the dollar. It seems as though they have successfully managed this.

Indeed the chart below shows the oil price in dollars, sterling and in euro, we have also put a trend line through the three different series. This clearly shows that oil price in sterling have been flat and in euros have actually declined. All this means is that the oil producers have managed to keep the oil price in real purchasing power terms flat.

It is clear that part of the rise in petroleum prices can be put squarely on the shoulders of a weaker dollar and driving the dollar lower would only serve to push crude prices up and pump prices up. This is causing some discomfort for the administration and it is the first sign that the lower dollar is starting to hinder rather than support Bush's campaign.

Of course supply and demand balances around the world also determine the oil price and it is extremely difficult to desegregate this impact from a falling dollar. To this end we ran an econometric simulation, and set the criteria as a 10% fall in the trade weighted dollar index and looked at the impact on exports and the oil price (we used the Oxford Economic Forecasting model).

As expected and the good news from thesimulation is that it pushes up exports by around 1.5% a year. This would have the theoretical desired effect of helping the manufacturing sector and should help manufacturing jobs, but due to the strong productivity growth this is just not coming through.

On the dark side the simulation pushes up crude prices by around $2 per barrel for a 10% fall in the trade weighted dollar. Given the dollar has fallen around 23% in trade weighted terms from April 2002 (the start of the trend decline of the dollar) one could argue that the dollar alone has pushed up crude prices by around $4.50 a barrel.

If we then take the price of crude at April 2002 ($26 bbl) we can attempt to approximate how much of the rise is due to cyclical factors and how much is due to the falling dollar. Taking the current price of $33.50 the oil price is up $7.50 from the point at which the dollar started its trend decline. This suggests that over half the increase in crude oil prices can be ascribed to the fall in the dollar.

It would be illogical to argue that the administration caused the weaker dollar, but we are suggesting is that effects of a weaker dollar that have so far been a political positive are starting to turn into a negative. Taking the conservative view that half the increase in crude prices is due to the falling dollar we can reach the following conclusion.

That pump price would be about 20 cents a gallon lower than at present and would not be a political issue. In fact energy in the CPI has added 0.5% to inflation if we say half of that is due to a falling dollar, then inflation is a ¼% higher than it would otherwise be.

This subtracts from consumer purchasing power and can be seen as equivalent to a $20bn tax hike. In addition, if the oil producers are able to keep the real value of oil constant whilst the dollar is falling it would take an even bigger fall in the dollar to turn the current account deficit around.

We expected the administration to try and encourage a more stable dollar in the run up to the election but it seems the implications of a lower dollar are already entering into the political arena albeit in an indirect fashion.

This is happening sooner than we thought and at some stage the administration may wish to change tack on the dollar from benign neglect to as more activist approach. The petrol pump argument illustrates the increasing politicisation of the dollar that we expected but it all seems to be happening sooner than we envisaged.