The jig appears to be up. Many factors have brought us to this point, but it seems that there are two paths left. One or the other will out, eventually.
On the one hand, the Fed may raise interest rates, and thereby support the dollar, which in turn will put downward pressure on oil, which is priced mainly in greenbacks. The alternative path is keeping rates unchanged and so allowing the oil bull market to run skyward unencumbered by any monetary policy braking.
In time, the outcome will be the same: slower growth, perhaps recession, with the possibility of a deep, long recession. Shifting the odds in favor of something tamer, it seems to this observer, requires a proactive monetary policy in the form of hawkish behavior from here on out. Yes, that will incur economic pain. But economic pain is now inevitable. The only question is how it’s administered?
If the Fed does nothing, and effectively allows the bear market in the buck to roll on, the threat of higher oil prices rises as well. In that case, an untethered increase in oil prices from this point will generate more demand destruction to push the U.S. economy, and perhaps the global economy, into recession. In time, that will pare oil prices to reflect the new, albeit temporarily adjusted supply/demand equation.
Alternatively, the Fed could engineer a similar outcome but with a higher possibility of imposing demand destruction gradually, with a kinder, gentler hand compared to the blowback from a runaway bull market in energy. There’s no guarantee, but if Bernanke and company take the lead and steadily tighten monetary policy, and speak forthrightly to the markets about their intentions, there’s a chance that the Fed can minimize the pain.
But let’s be clear about what’s possible, and what’s not. To the extent the higher energy prices reflect higher demand and a growing struggle to find new supplies, monetary policy, enlightened or otherwise, can’t change geologic reality. At the same time, some degree of higher energy prices are a function of the weak dollar. Exactly what degree is unknown. Whatever the degree, it’s almost certainly a small influence on oil prices. Still, the Fed should use its influence, limited though it is.
Rest assured that if the Fed doesn’t act, or doesn’t act with sufficient speed or authority, the markets will eventually do the central bank’s job. In that case, the damage may be greater than if the Fed acted pre-emptively and prudently.