Oil Markets and Currencies

David Kotok, over at the Big Picture:

Today we focused on an issue involving currencies and the current status of oil markets. The issue derives from the fact that oil producers tend to allocate their reserves against an index or other proportion, and plan accordingly in the deployment of their reserves. Since the producers are mostly Middle Eastern or North African, those reserves tend to have some political bias. In some cases, it is against the dollar and in favor of other currencies and assets. The same thing happens with Asian reserves, which tend to lean in favor of the dollar in greater proportion. The difference between the two creates an interrelationship among currencies, their exchange rates, and various levels of economic activity and price change throughout the world.

Picture the condition of a sovereign-wealth-fund manager in the Persian Gulf. The price of oil goes up by 30 dollars a barrel, and in come unexpected additional billions of dollars. On receipt, they raise the allocation of US dollars beyond the typical benchmark index. The portfolio manager then has to sell some of the dollars and redeploy them into another currency, such as the euro, yen, pound, or others. The effect of the sale is to weaken the dollar and strengthen the euro; but because commodity prices are all priced in dollars, the secondary effect raises commodity prices of other items like industrial metals, precious metals, or food.
Market participants then see the weakening dollar, the rising price of oil in USD terms, and the rising price of commodities in USD terms, and the cycle intensifies. Does this mean inflation in the general price level? What is the transmission mechanism that takes a food price or gasoline price and converts it to a rising level of all prices, or most prices, or more than half of all prices? Here is where the concept gets difficult.

In Europe, the authorities of the European Central Bank incorporate food and energy into their inflation measures. In the United States we do not; we use something called core inflation. We determine that food and energy prices are the result of shocks that are beyond the control of the Federal Reserve and, therefore, are not reflective of central bank policy. The European Central Bank sees it quite differently.
The ECB has raised its policy interest rate. It is worrying about inflation, looking at the energy price shock, and watching the price of Brent crude. It is seeing the rising prices of food, and tolerating the risks of sovereign debt restructuring, other sovereign debt issues, a banking system that still needs repair, and possible economic weakness in some regions.
The Federal Reserve, led by Chairman Bernanke, Vice-Chairman Yellen, and NY Fed President Dudley, has staked out a different position. They are looking at core inflation. They are worried about the large negative output gap reflected in the high unemployment rate, and they are leaving policy interest rates at present levels. Such are the differences between the two central banks.