Oil and the FedMay 23, 2008So the Federal Reserve is signaling that its rate-cutting binge may finally be over, and we can be grateful for that small favor. The consequences of its easy-money bender will roll through the economy for years to come, however, so it's important to draw the right lessons.
All the more so because the Fed's most senior officials continue to insist that recent price increases have almost nothing to do with . . . monetary policy. Imagine that. The latest to wash his hands of responsibility for the value of the currency is Donald Kohn, the Fed's current Vice Chairman and long-time resident intellectual. In a speech in New Orleans this week, Mr. Kohn acknowledged soaring oil and food prices, but he blamed them on global supply and demand for corn, oil and so on.
"As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies," Mr. Kohn explained. "But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one."
If Mr. Kohn really believes this, we're in more trouble than we thought.
For starters, he is simply wrong about the relative price of commodities and other currencies. The price of oil has risen far more rapidly in dollars than it has in euros since 2002. David King points this out today with a chart that we have run in the past. Had the Fed merely kept the dollar stable against the euro, the price of oil would be closer to $80 than to $131 a barrel.
No one denies that supply and demand play a role in commodity prices, but oil on global markets is denominated in dollars. When the value of the greenback falls, and especially when speculators anticipate that it will fall further, oil sellers demand more dollars for their product. This was the experience of the 1970s, the last time the Fed lost its monetary moorings, and we have been living through a sequel this decade.
As recently as last August, the dollar price of oil was only $70. The current spike in oil and other commodity prices coincides almost exactly with the Fed's decision to turn the monetary spigots wide open as a response to the credit crunch. They have since taken the fed funds rate down to 2% from 5.25%, while commodity prices have soared.
Oil prices have jumped recently on reports of higher global demand, but this too reveals a Fed miscalculation. The central bankers have justified their rapid plunge down the yield curve as necessary to avoid a recession, arguing that a slowing economy would mitigate any inflationary impact. Yet the economy has been far more resilient than either the Fed or its Wall Street beseechers expected, and we may still avoid a single negative quarter for gross domestic product this year.
As for inflation, this week's producer price numbers were alarming. The wholesale inflation figure is up 6.5% in the last year, despite an anomalous April decline in gasoline prices. That decline won't continue with $131 oil. With even the Fed's phony "core inflation" rate well above the 2% fed funds rate, Mr. Kohn and company are running a negative real interest rate policy.
No wonder inflation expectations have been rising. Economist Michael Darda points out that the University of Michigan's year-ahead inflation survey hit 5.2% in May, the highest reading since 1982. Yet some at the Fed continue to insist that inflation expectations are "well-anchored." Anchored on what planet?
The price for this Fed blunder is going to be very high, and we don't mean only at the grocery store or gas station. If inflation doesn't fall, the Fed will have no choice but to start raising rates again, perhaps rapidly and perhaps soon. That could put a damper on any economic recovery, especially if it coincides with the huge tax increase that Barack Obama is promising next year.
Politically, meanwhile, the Fed's commodity spike is proving to be deadly for the Republican Party that occupies the White House. As the nearby poll question shows, rising prices overall and gas prices specifically are by far the public's biggest economic worries. Voters are understandably furious because they can see that their real incomes are falling as prices rise. This is the real source of middle-class economic anxiety ? not the housing recession, or jobs, or the liberal obsession with income inequality.
Republicans may be punished this November for forgetting that the Reagan policy mix had two levers ? tax cuts and stable money. The Bush Administration got tax policy right. Its tragic error was falling for the siren song of dollar depreciation, and abetting a Federal Reserve that even now seems not to comprehend the damage it has done.
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