The financial world will always remember 2020 as the year of the pandemic – the year that sent the U.S. equity markets to the fastest bear market ever.
For a few weeks, the panic was everywhere – from stocks to currencies, volatility increased, and people were looking for safe-haven assets.
While the plunge in the stock market is worth remembering, there is another chart that made history in 2020. For the first time ever, the WTI crude oil price turned negative. So shocking was the move that no one thought it possible. In fact, not even the clearinghouse, responsible for settling the trades on the futures contracts, as no one can explain the hesitation in announcing if the price of a commodity can settle below zero. The announcement came late in the trading day, and from that moment on, from the moment that the clearinghouse gave the blessing, the mayhem began. WTI did not find a bottom until way below zero. More precisely, it dived beyond -$37.
Negative Oil Prices
Lower oil prices are a central bank’s nightmare. Since the Reserve Bank of New Zealand introduced inflation targeting a few decades ago, the model was quickly adopted by other central banks in the developed world. Soon enough, most of them targeted inflation around 2% – their definition of price stability.
The problem with oil is that it is a driver of other stock prices. Higher energy prices trigger higher inflation and the other way around. Imagine you are a central bank facing the worse economic crisis since the world war, or even worse, as the COVID-19 pandemic affected all economies throughout the world. The first response is to lower the interest rates to the minimum possible and to start buying government bonds. Known as quantitative easing, the program aims at lowering the financial conditions even more.
Also, it is supposed to stimulate inflation, thus making it easier for central banks to explain the measures in front of critics, bringing their mandate to the forefront. Only when the price of oil settled below zero, central banks witnessed a check-mate situation. Having the interest rate already at the lower boundary or below zero and running quantitative easing programs, central banks found themselves unable to react.
In fact, we may say that the low price of oil in 2020 will be one of the main contributors to influence monetary policy decisions in the years to come. You see, lower oil prices push inflation expectations even lower. Either the model breaks soon, or we will see central banks changing their definition of price stability.
The Fed in the United States was the first one to react, who will be next?