GREENSPAN TO PLAY “CHICKEN” WITH OIL?

            As do most analysts and writers, I have my own stable of fellow travelers and business associates I talk with, usually on a daily basis.  Never so smug that I think I know the answer to everything, I always ask for their opinion and perception on things.  Leading up to last week’s F.O.M.C. meeting, my refrain to them was that—though the central bank would surely raise short-term interest rates by another 25 basis points—they could not wait any longer in more boldly dealing with the drag on the economy caused by the rise in the price of oil, which has taken a barrel of crude to yet new highs well over $45.00.

            Though the F.O.M.C. did as I expected, the implications of what they said about oil created more questions than were answered.   As I wrote in July’s issue (“Forget About a ‘Neutral’ Federal Funds Rate,” beginning on page 2) I, for one, don’t think the Fed will have either the nerve or the ability in the end to take the federal funds rate—now at 1.5%—to the 3-4% level many expect to see over the next 12-18 months.  Not the least of my reasons for believing this is the impact of higher energy prices on both corporate and household bottom lines.  By implication, an economy weakening due to energy costs does not need, nor can it absorb, interest rates much higher than they presently are.

            The Fed did not necessarily suggest, though, that it views rising energy prices still as much more than “transitory,” even though it did finally admit that oil’s spike was chiefly responsible for the “softness” in the economy.  Higher oil or not, however, the F.O.M.C., in a post-meeting release considerably more “hawkish” than had been expected, stated that, “The economy nevertheless appears poised to resume a stronger pace of expansion going forward.”

            Clearly, the Fed’s statement was intended to reassure both Wall Street and Main Street that, overall, all is still well.  The economy’s growth is more self-sustaining than the worry warts think.  In short, the Fed did nothing to dispel the notion that, therefore, the direction of interest rates is still higher.  In fact, it reinforced its new trend by concluding its statement with the promise—after repeating its “measured pace” mantra with which it intends to remove its “policy accommodation”—that, “Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” (Emphasis added.)

            It may well be that this suggestion that the pace of rate hikes could increase if oil refuses to come back down (or perhaps keeps rising) is nothing more than the latest manifestation of the Fed’s “speak loudly and carry a toothpick” behavior.  Maybe in the end they really won’t raise rates much more, especially if it’s demonstrated over the next few months that the recent soft patch is something much more.

            In any case, it will be extremely interesting to watch how the relationship between Fed policy and energy prices continues to unfold.   Some have blamed then-Fed Chairmen Arthur Burns and G. William Miller for actually exacerbating the oil price spike of the 1970’s by “accommodating” it via easy money.  Following President Nixon’s removal of the dollar’s anchor to gold, the declining dollar meant that commodities such as oil that are priced in dollars had to go up.  Unfortunately for (first) Chairman Burns, the dollar’s decline was soon accompanied by a nasty recession; thus, Burns held to what at the time was perceived to be an accommodative monetary policy to try to blunt the negative effects of oil’s rise. 

Guess what?  Not only did he fail to move the economy forward with that policy, he was arguably responsible for driving the dollar price of oil higher still, as his actions weakened the U.S. dollar even more.  The hapless Miller did no differently in the short time he served as Fed Chairman; and by the time the 1970’s were drawing to a close oil was near $40 per barrel, gold was over $500 on a consistent basis, and the word “stagflation” had become a part of our vocabulary.

In an interesting exchange early this past week on CNBC, that network’s resident economist Steve Liesman (one of the better intellects there) and technical guru John Bollinger carried on an interesting discussion about this history, as well as why Fed Chairman Greenspan should not repeat it.   “The very worst thing we can do is monetize this oil price shock,” Bollinger said firmly, in pining for Greenspan to follow through on a healthy dose of his measured rate hikes.  His implication was that this action alone could help rein in oil’s price, as 1) the dollar would thus be bolstered and, theoretically, lead to price declines in commodities like oil that are priced in them and 2) sufficiently high interest rates would cool off the economy sufficiently as to also reduce demand for the black gold.  In the end, following his logic, Greenspan’s medicine—though harsh—would be for our ultimate benefit if it meant that the eventual reduction in energy costs would more than offset the “tax” of somewhat higher interest rates.

Now, I have always regarded Bollinger rather highly; and still do.  However, in coming up with this desired roadmap of how he wants to see Greenspan and Company deal with rising energy costs, he forgets (or dismisses) two things.  First, Greenspan has already monetized higher oil (and real estate, and stock, and bond, and many other) prices.  He has already done, via his long maintenance of an “emergency” federal funds rate of 1%, as much as Burns and Miller did to stoke future inflation.  So, I humbly suggest, the question Bollinger should have asked is whether Greenspan intends to continue doing what he’s already started, or instead finally morph into Paul Volcker himself.

Second, while it’s true that the Fed’s past lax monetary policy has indeed helped drive commodity prices higher than they might arguably have gone by now, this is plainly not the 1970’s where oil is concerned.  As I wrote in the cover story of April’s issue (“A New Kind of Energy ‘Crisis’”) the surge in oil prices has been just as much caused by soaring demand as anything.  We are not dealing with embargoes or other artificial supply constraints that are indeed “transitory” by nature.  Sure, at least some of the recent frothiness has been caused by a combination of speculation, risk/terror premiums and such.  Yet the inescapable fact is that all the world’s major producers are pumping at or very near their capacity already, and selling their oil at current prices to very willing buyers. 

Short of a major new recession that affects the world (which will almost certainly be the outcome if the Fed decides that, of all possible times, it’s now going to “fight inflation”) energy prices are sure to head higher longer-term, even if they blow off some steam from time to time in the process.  It’s arguable whether Fed policy alone can do much about this, especially if China one of these days does what I expect regarding its currency policy (I talked about this in my April essay “The World Turned Upside Down” and discuss this again in the “Financial Potpourri” section farther along in this issue.)

Maybe Greenspan will be able to turn away from this game of “chicken” he’s getting pulled into with oil’s price.  Maybe Osama will be apprehended.  Maybe the uprising in Najaf will be crushed, and democracy will truly, finally break out in Iraq.  These things might well remove some of the “terror premium” in oil.

Maybe Saudi Arabia will be able after all to substantially increase its own production.  Maybe Russian President Vlad Putin will say he’s sorry for going after Yukos’ crooked chief Mikhail Khodorkovsky and fraying our nerves.  Maybe countries harboring half or more of the world’s population will decide that they’d rather stop growing, using so much oil (as well as other increasingly dear commodities,) and otherwise trying to improve the lifestyle of their folks out of concern that they’re harming the lifestyle of U.S. consumers.

I think you can ascertain my doubt over many—or maybe any—of these things happening.  Thus, if Greenspan decides to attack the oil price, it will be at his—and the U.S. economy’s—peril. 

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