Tuesday, March 18, 2008

A quick note on inflation

The dollar keeps falling against the Euro. Oil and gold have hit new highs. Bernanke has printed a few billions of extra bills to bail out a bank. The sky is falling! I've put together a quick and dirty chart on the change in prices of oil, gold and Euro. It doesn't look all that bad for the dollar...

What we see here is a flight to commodities, but not a serious inflation of the dollar. The scale is from 100% on January 1 2007 to yesterday, and as we can see, during that time the price of Brent crude (spot) appreciated by slightly over 80%. That's a huge jump, but look at what was happening to the oil price in Euros and in grams of gold: until late August 2007 all three prices changed nearly identically. This indicates that oil prices have moved independently of the dollar until then, influenced only by supply and demand (and the perception of those). After that, two things happened: the dollar started growing weaker against the Euro, and the gold has taken off. Oil prices in grams of gold (Aug) has plateaued out.

The vast majority of the exchange rate swing took place between September and December; for the rest of the time the rate moved only very slightly. This is attributable to a number of factors, but a 15% exchange rate swing for two currencies that are not tied (in fact, they appear to be in global competition, not only for the distinction of reserve currency, but also as the price factor for two major import blocs) is not all that large. Gold, on the other hand, has grown in price primarily after the exchange rate between the dollar and Euro stabilized, and in fact, it's grown faster than the price of oil. This indicates a flight to safety, not excess inflation. Given inflation of around 3% in the Eurozone and 4% in the US, the growth in the price of gold was abnormally high, indicating a possible bubble. Moreover, considering that the commodity prices changed largely when there was little or no change in the US$/EUR exchange rate, we can safely assume that commodities have moved independently of the price of the two currencies, and not as a result of excess inflation.

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