With euro/dollar passing 1.50 there are many commentators saying that rising oil prices and falling dollar are mutually reinforcing processes. Some even see causality going both ways, one example is below:

“The lower dollar reduces supply and increases demand, thus raising oil prices,” explains Alhaji, who is an Associate Professor of Economics at the College of Business Administration, Ohio Northern University. “As a result, the value of US oil imports increases, which in turn widens the trade deficit, which weakens the dollar further.”

There are other views. Menzie Chinn in his dollar/oil post shows evidence that relationship between dollar and oil is weak at best, and possibly there could be a common shock causing both prices (dollar price of oil and euro/dollar exchange rate, or dollar RER) moving in opposite directions. He follows Frankel in postulating that monetary policy shocks could affect both dollar and oil.

You also can find a very interesting story by Benassy-Quere et al. (CEPII paper )about emergence of China as a global player and its role in the dollar oil equation. Authors find (in a cointegration framework) that in the long run 10% increase in the oil price was associated with an APPRECIATION of the dollar real effective exchange rate by 4.3%. Authors develop the model which explains why emergence of China could have reversed the relationship. In short falling dollar makes renminbi very cheap (as a currency pegged/closely linked to the dollar) which boosts China export led growth further accelerated by reserve accumulation and related monetary expansion. Because China uses a lot of energy per unit of output it leads to higher demand for oil and to higher oil prices.

The bottom line is that there are many models and many good stories explaining dollar and oil price changes. I like the China story, as we are finding more and more that China has an impact on dollar oil relationship, on world food prices and on world commodity prices (it uses half of world cement output f.ex.). But I think that market strongly believes in negative dollar/oil relationship, so if many investors decide to take directional view speculation can extend trends well beyond levels justified by fundamentals (do they matter these days anyway, as we are in the crisis of trust when world liqudity is abundant).

Should this be the case we could end in an unwelcome situation. Last thing the world needs today is oil price going to 200 dollars per barrel (although I did put my forecast out six months ago, that oil will go to to 200 first and then it will fall to 2 amid disruptive innovations rapidly reducing demand for oil). And I am not worried about recession, Shumpeterian creative destruction is needed these days, but I am worried about further enormous buildup of global imbalances implied by surging oil prices.

I do not know how it will end. I predict that after going to 1.50-1.60 dollar will reverse and end 2008 stronger that it started against the euro. But I am worried that monetary and fiscal medicine applied today to avoid recession will aggravate global imbalances problem. So if we avoid hard landing this time, and the global plane takes off again, the next safe landing would require enormous skills and wise coordination among global pilots.