Oil, The Fed & everyone's economic future

Last month, your correspondent weighed in on oil prices, suggesting that they'll sooner determine your economic future than just about anything else. Oil prices have been falling lately and the Dow Jones Industrial Average is now above 12,000. This just in, from the London Financial Times' investment editor:

The Short View: On the Fed and oil
By John Authers, Investment Editor

Published: October 25 2006 18:13

"The Federal Reserve Open Market Committee left the Fed Funds rate unchanged at 5.25 per cent on Wednesday, and warned that 'some inflation risks remain'. The market’s response to Ben Bernanke, Fed chairman, mirrored the deathless one-liner of Mandy Rice-Davies, caught up in a notorious British scandal of the 1960s, when told Lord Astor had denied sleeping with her: 'He would, wouldn’t he?'

"The market brushed off the ritual hawkish sentence at the end of the Fed’s communique, and also gave a Rice-Davies response to Jeffrey Lacker, who for the third time dissented and voted to raise rates. The rest of the statement was doveish enough – 'inflation pressures seem likely to moderate over time' and 'the economy seems likely to expand at a moderate pace' – to convince traders that the Fed believes the economy is heading for a 'soft landing'.

"They had feared something more hawkish, so this was enough to trigger an afternoon rally. The dollar weakened, the yield on the 10-year treasury bond shed 4 basis points (making 6 basis points for the day), and US stocks showed solid gains for the day.

"But was the Fed decision really the most important market news on Wednesday? Earlier, the energy market was shocked by supply figures showing that US crude oil inventories actually fell last week. The market had expected a rise. The result was a sharp bounce in oil prices. Nymex crude futures gained 3.6 per cent to stand at $61.52 per barrel, above the $60 floor that the Opec group of oil exporters is trying to establish.

"This matters. The 'reduced impetus from energy prices' was a factor the Fed named for believing that inflation pressures would moderate over time. And there is good evidence that the current remarkable world stock rally has more to do with falling oil prices than with the Fed’s 'pause' on interest rate rises.

"Data from Tim Bond of Barclays Capital show that since the start of 2004, the negative correlation between forward price/earnings ratios on the S&P500 and spot oil prices has been 0.87. Thus, 87 per cent of falls in multiples could be explained by rising oil prices, and vice versa. And if oil keeps rising, expect equities to fall, whatever the Fed says."

So there you have it. The house expert at the Financial Times writes that there's an inverse relationship between oil prices and stock prices.

More fodder for the Democrats. Not only could they create a campaign centered around making U.S. foreign oil dependence a national security issue, but now they could also make oil prices an economic security issue for the common man.