The positive correlation between oil prices and the US dollar index inverses, easing the burden on other countries.
By
ARI KUNCORO
·6 minutes read
SALOMO TOBING
Ari Kuncoro
International prices for various commodities including crude oil are generally based in in United States dollars. Historically, oil prices are inversely related to the strength of the US dollar (Verleger; 2023). For net oil importing countries, it provides a kind of partial compensatory effect that can reduce the cost of oil imports.
This inverse relationship occurs because the US had, for a long time from 1980 to 2020, been a net oil importer. Rising oil prices increase the value of oil imports so that the US has to increase the circulation of dollars in the world, thereby weakening the dollar.
This inverse relationship or negative relationship has turned unidirectional since the US became a net oil exporter in 2020 with exports of 8.51 million barrels per day (Farley; 2022). Since then, the increase in oil prices has caused the US dollar to strengthen because of the rise in the demand for US dollars in the world.
The Ukrainian-Russian war, which has been going on for more than a year has further strengthened this positive relationship. Economic sanctions against Russia, which is an oil producer, have led to an increase in the demand for US oil. The price of West Texas Intermediate (WTI) oil almost touched US$120 per barrel in mid-June 2022.
In sequence, a unidirectional relationship between world oil prices and other commodities also occurs, either through substitution in the production chain or expectations on the futures market. Not long after oil prices reached their highest point, food and energy commodities also followed suit.
As an example, the price of wheat reached $13 per bushel. The price of crude palm oil (CPO) increased to 7,000 ringgit per ton. The price of coal reached its peak at $460 per ton in early September 2022. The price of natural gas was recorded at $9.75 per million metric British thermal units (MMBTU).
Chain reaction circle
Global inflation then returned to the US economy through the world supply chain so that domestic inflation reached a peak of 9.1 percent in June 2022. The US central bank (the Federal Reserve) responded to the high inflation by increasing its benchmark interest rate.
The impact strengthened the appreciation of the US dollar because the capital that returned to the US added to the exodus of capital due to the Russia-Ukraine conflict. The US dollar index reached 114 in early October 2022.
This is a double whammy for developing countries which are net importers of food and energy. Not only did prices of commodities increase but also the US dollar, which led to a rise in the cost of imports in domestic currencies.
The prices of oil and other commodities increased too rapidly, while the high US dollar index cannot last in the long term because it is not in accordance with the carrying capacity of the world economy. The chances of a global recession are also increasing, especially because the world's economic locomotives, such as the US and European countries, are raising their benchmark interest rates to reduce inflation. This also has an impact on contraction on the production side due to the decline in working capital credit.
The purchasing managers' index (PMI) for the manufacturing sector in the eurozone issued by the S&P was in the contraction zone (below 50) and continued to decline in the first three months of 2023. In March 2023, it was 47.3. The same thing happened in the United Kingdom, where the latest PMI figure was recorded at 47.9. In the US, the PMI bounced back to an expanding territory of 50.4 in April, after contracting for the fifth month in a row.
This complexity means that efforts to reduce inflation will take a long time. As a result, the benchmark interest rate has to be increased several times. For the US it took nine months to bring inflation down consistently from a peak in June 2022 to 5 percent in March 2023.
In the eurozone, inflation rose first from 10.6 percent in October 2022 due to a widening output (demand versus production) gap before dropping to 6.9 percent in March 2023. The UK is an exception, where the persistence of the output gap means inflation has remained steady at the double-digit rate of 10.1 percent.
Interestingly, the series of hikes in the benchmark interest rate has raised expectations of a recession and triggered a banking crisis in the US. These are two important factors that have contributed to the decline in global inflation through the oil and commodity futures markets.
WTI oil prices briefly fell below $70 per barrel, then rose again to around $80. Last week, it fell again to about $75. Meanwhile, Brent was recorded at $80 per barrel.
Other commodity prices also fell. Wheat prices on the commodity futures market, for example, fell below $6.5 per bushel, which is the lowest price in the last 21 months. Last week's CPO price was below 3,500 ringgit per ton. The price of coal as an energy source has fallen to around $190 per ton.
Global impact
The above factors also accelerated the decline in the US dollar index to near a neutral 100. This trend was strengthened by the return of investment flows to emerging countries, including Indonesia. At the end of September 2022, the US dollar index reached 114, but then gradually dropped to the range of 101-102 in March-April 2023.
Here, the positive correlation between oil prices and the US dollar index inverses, easing the burden on other countries. However, this unidirectional relationship between the US dollar and oil prices also raises new problems, namely the fluctuations in the commodity cycle between booms and busts widen.
In addition to geopolitical tensions, this factor is also a consideration for diversifying foreign payment instruments, no longer solely dependent on the US dollar. The idea comes from the effective exchange rate model (Meese and Rogoff; 1996), which is similar to risk diversification based on trade-weighted effective exchange rates.
The positive correlation between oil prices and the US dollar index inverses, easing the burden on other countries.
The BRICS countries (Brazil, Russia, India, China and South Africa) have taken this idea further toward de-dollarization, seeking alternative currencies for international transactions. Indonesia has also made efforts to reduce exchange rate fluctuations in the form of local currency settlement.
The domestic economy, which grows based on rupiah-oriented mobility is a cushion against the appreciation and fluctuation of the US dollar. Even though the rupiah sharply depreciated at the end of November 2022 but it was able to recover to Rp 15,700 per US dollar.
The US dollar index and falling oil prices later reversed the momentum. Since January 2023, the rupiah has strengthened toward its ideal equilibrium. Until the end of last week it had reached Rp 14,800 per US dollar.
This trend has kept imported inflation under control during the first quarter of 2023. Inflation in March, for example, fell to 4.97 percent from 5.47 percent in the previous year. This is the basis for maintaining domestic growth momentum in 2023, anticipating a slowdown in US growth as the world's main economic locomotive.
ARI KUNCORO, Rector of the University of Indonesia.
(This article was translated by Hendarsyah Tarmizi)
