The oil equation

Throughout the 1970s the rise in oil prices meant that interest rates were headed higher. Higher oil prices meant higher inflation, and higher inflation always translates into higher interest rates, eventually sending the economy into recession. This relationship worked in the opposite direction, as well. When oil prices came down, interest rates came down with them, and the economy got a noticeable boost.

Then something changed. Sometime in the late 1990s, the traditional relationship between oil, inflation, interest rates, and the economy became unhinged. Oil rose in the late 1990s in lockstep with an acceleration in the economy, crashed with the economy in 2001, and then soared in 2003-4 with the recovery. Oil soared, in fact, to new record highs above $50 a barrel.

And what happened to interest rates? They continued on their downward journey—literally hitting half-century lows as oil prices were hitting record highs.

So what's going on here, and why does it matter to retailers?

Market bubbles

While a good deal of press and professional economic attention has gone to searching for a bubble in the housing market, a real, unmistakable bubble is forming under the markets for oil and U.S. Treasury bonds.

Markets are a balance of fear and greed. Their genius is the harnessing of two of humankind's lesser sins to create an institution that generally produces a greater social good: the efficient distribution of capital and goods. When markets fail, it's because greed and fear slip out of balance.

In the case of oil, however, greed and fear are working in the same direction—for now. Fear of supply disruptions, coupled with good old-fashioned speculative greed, has pushed prices to record high levels. At some point in time, the buildup in petroleum inventories will push the market toward a tipping point. When that happens, both greed to cash in on gains and fear of price declines will force liquidation and a significant drop in prices.

The same thing is happening in the credit markets. Fear of terrorism, another economic downturn, and an unwillingness to take risks has resulted in a mad rush to the safety of U.S. government bonds, and record low interest rates. All market bubbles are a search for the greater fool. Market buyers make their purchases not because they think they're buying something of value, but in the hope of finding a greater fool than themselves, who will pay an even higher price for the bubble product. It may take some time, but in both oil and Treasuries we'll eventually find the greater fool.

The decline in oil prices will have a positive impact on food and drug retailers. Lower gas prices will also give a boost to nongas consumer spending. A penny increase in the average price of gasoline costs U.S. households on average $20 million every week. Since the first of the year, gas prices are up over 40 cents a gallon, taxing all households an additional $800 million every week.

Lower gas prices will also have a positive impact on the cost side of the business. Distribution costs have been creeping up over the course of the past year as the cost of gasoline has risen. A lower price for gasoline will renew downward pressure on distribution costs.

Carl Steidtmann, chief economist for New York-based Deloitte Research, is a recognized expert on economic forecasting of retail sales activity, consumer trends, and general economic conditions.