Interest rates have become the latest concern that officials around the world have been discussing. Earlier in May, the US Federal Reserve decided to increase interest rates by half a percentage point, within the range of 0.75%-1% following a smaller increase last March. The Bank of England also raised its interest rates to their highest level in 13 years and there are even reports that they may raise it yet again.
All of this is being done to combat one phenomenon that politicians and people alike dread: inflation. Raising interest rates has become the textbook antidote to tackling any inflation crisis. However, when the matter is related to how heightened interest rates may affect the oil and gas markets, the matter becomes more complex.
The reality is that oil prices and interest rates do not have a tightly correlated relationship, since it varies based on the region and economic situation of a particular country. There are many factors that could drive both interest rates and oil prices in different directions, and hence coming up with a clear-cut formula to define the relationship between these two factors can prove to be challenging.
Some economists argue that oil prices and interest rates may have an overall inverse relationship suggesting that heightened interest rates could increase consumer and manufacturer costs. This would thereby cause a decrease in oil consumption since consumers and business owners will try to spend less on driving and/or other business-related transportation activities. If there are fewer drivers, then that means there’s less demand for oil which would cause a dip in oil prices. However, when interest rates decrease, there is more freedom for consumers and corporations to borrow and spend, which would cause an increase in demand for oil and therefore oil prices would soar.
To explore the relationship between oil prices and interest rates based on another theoretical model, some economists have argued that higher interest rates strengthen the dollar against other currencies. For at least US companies, a stronger dollar means that their enhanced buying power will allow them to buy more oil and therefore oil prices will increase as a result of increased demand. Hence, it is arguable that in the context of the United States, there is a direct relationship between interest rates and oil prices, especially when there’s a direct influence on the dollar.
Now, this all may sound nice and simple, but with Russia’s invasion of Ukraine sending shockwaves throughout the global markets, the economics of interest rates and the energy market became a whole lot more complicated.
In Europe, officials have been divided on the best monetary policies that need to be implemented to curb inflation and keep energy prices under control, and at the center of these disagreements is the interest rate. Last February, European Central Bank (ECB) President Christine Lagarde asserted that raising interest rates would not have an immediate impact on the energy prices. “I think it is really important to understand what is fueling inflation, so that we can also determine what will help in maintaining price stability,” Lagarde said in a report from EURACTIV. “Now, if we were to take monetary policy action by way of gradually putting an end to asset purchase prices and rapidly hiking interest rates, would that have an impact on energy prices right away?..I don’t think so.”
In another report from The Business Times last April, Lagarde reaffirmed the position of the ECB at the time. “Inflation in Europe is very high at the moment. Fifty per cent of that is related to energy prices,” Lagarde said in her interview with CBS. “If I raise interest rates today, it is not going to bring the price of energy down.”
Nonetheless, in a recent blog post written on the ECB’s website, Lagarde announced that the ECB is expected to raise interest rates in July and September. Whether this will have any significant effect on energy prices or not is yet to be determined.
In the face of the challenges that the world is currently facing, monetary policies taken to resolve global crises require careful consideration, especially when it comes to energy markets. The relationship between interest rates and energy markets currently is and will remain to be complex, which makes policy research in this area even more essential. Experts need the time and resources to perform more exact studies to ensure that the right measures are taken to curb inflation. This will be vital in determining sound monetary policies for the years to come.