Interest Rates Impact Oil Prices

Federal Reserve Raises Interest Rates

The Federal Reserve increased interest rates by a quarter percent this week, bringing target rates to 1.75% to 2%, the highest level since 2008. The Fed also indicated at least two more hikes will be coming out before the end of 2018. We’ve spent a lot of time recently talking about OPEC and other oil supply/demand trends, so today we’ll quickly examine why interest rates matter to the economy and to oil prices.

Interest rates are a lever used by the Fed to keep the economy running smoothly. During recessions, they lower interest rates to make it easier to borrow money – more borrowed money means more money flowing through the economy. As the economy strengthens, they increase interest rates to keep inflation in check. Looking at the chart below, courtesy of the NY Times, the near 0% interest rates from 2009-2015 was unprecedented in US economic history, so it will take a lot of rate increases to return to a historically “normal” level, around 5%.

Source: New York Times

Interest rate increases cause a strengthening of the dollar – higher interest rates in the U.S. mean American bonds have higher returns relative to other countries, so investors rush to buy U.S. dollars so they can buy American bonds. The dollar and commodities such as crude are inversely correlated – as investors put their dollars into bonds, there are fewer dollars remaining to spend on oil contracts, weakening trading demand and causing prices to fall. Thus, this week’s interest rate hike has created headwinds for oil prices, making crude’s weekly gains that much more surprising.

Additionally, as we noted above, interest rates are used as the economy grows to dampen its growth, smoothing out both the peak and the trough of the business cycle. Thus, higher interest rates will moderate the economy somewhat over the next few months, which in turn will reduce overall oil consumption for the U.S.