The stakes are always high when the Federal Open Market Committee meets. But when the Fed convenes its interest-rate-setting board tomorrow, the tension between risk and reward threatens to be the highest in recent memory.
The reason? Oil. The price of crude is creeping into every conversation in matters financial, and the price of money is granted no exception. The question: what is a prudent Fed funds? Always a tricky question, even under the best of circumstances, but these are less than the best of circumstances and the times are more than a little tricky.
This, after all, is a world marked by rising energy prices. Whether the Fed should consider the trend or ignore it is the query du jour. Yes, Fed funds have jumped to 2.5% from 1% in less than a year, and so one could argue that your public servants in the central bank are awake, alert, and turning the monetary wheel in an appropriate fashion. But before we break out the vintage champagne, it’s also worth noting that by the gauge of the consumer price index the central bank hasn’t kept the price of money rising as fast as inflation. The real Fed funds rate, in short, remains negative.
That’s nothing new, of course: the real Fed funds rate has been negative since 2002. The difference is that inflationary pressures in 2002 were a shadow of their current incarnation. To be sure, the latest CPI report hardly depicts runaway inflation. But with inflation advancing at a 3% annualized pace as of January, that’s a world above the 1.1% rate logged for a time in 2002.
If there’s one lesson that arises out of the mistakes made in the name of monetary policy of the last 40 years, the deputy governor of Norway’s central bank observed in a recent speech, it’s the need to be proactive and forward looking.
The past, of course, is crystal clear. It’s the future that raises doubts and inspires hope, not necessarily at the same time. The Fed arguably is now faced with a significant milestone in its management of the nation’s money supply in terms of deciding what, if anything, to do about the price of oil. The central bank has only one lever to work with so, in theory, the decision is fairly simple. But the factors driving that decision are as complicated as any in analyzing the economy.
Namely, does the prospect of rising, or a sustained higher oil price, raise the inflation threat? If so, should the Fed should raise interest rates with an eye on slowing the economy so as to take some of the marginal demand growth, at least for the moment, out of the oil market?
The situation is complicated by the fact that the Fed has a dual, and at times contradictory mandate: maximizing employment and minimizing inflation. Succeeding with one can easily generate failure, or something less than robust success, with the other. The study of the oil-price shocks of the 1970s and 1980s presumably has cast enlightened choices onto the desks of policy makers, but in practice the choice between jobs and inflation still lurks, albeit in muted form of late. Of course in the long run, as the 1970s so starkly remind, there’s really no choice.
Meanwhile, there’s plenty of talk. Fed Governor Edward Gramlich opined last September that there are no easy monetary policy answers in managing oil shocks today than there were in decades past. “Today the question of how to respond to oil price spikes is better understood, but the outcomes are no more pleasant,” he asserted. “It is virtually inevitable that shocks will result in some combination of higher inflation and higher unemployment for a time. But I must stress that the worst possible outcome is not these temporary increases in inflation and unemployment. The worst possible outcome is for monetary policy makers to let inflation come loose from its moorings.”
The worst possible outcome is in fact what worries one David Gitlitz, chief economist with TrendMacrolytics, who warns in an essay to client today, “Record crude prices mean a monetary mistake could be not just dumb, but disastrous.” Some at the Fed look at the recent past and conclude that since the economy’s chugged along nicely despite the higher oil prices there’s little to worry about on this front. “This reasoning,” Gitlitz writes, “also accords with the idea that since the oil price moves have apparently been marked by significant speculative excess, they are not a ‘fundamental’ factor that need be of particular policy concern.”
Of course, it all depends on what your definition of “fundamental” is. But as Gitlitz points out, and detailed in an earlier piece, the dollar price of oil is up significantly more so than crude’s euro-based jump. The implication: oil’s rise is partly due to the fall in the dollar. That’s hardly a radical notion, given that oil is a global commodity priced in dollars and that the U.S. is the world’s leading importer of the stuff.
Clearly, there are fundamental factors behind crude’s bull market, and in the long run those factors tower over all others. But Gitlitz and others remind that the Fed’s sluggish reaction to maintaining the dollar’s value isn’t doing oil consumers any favors. Granted, oil per se doesn’t come under the central bank’s purview, but the greenback’s health is priority one for Greenspan. And since oil’s purchase in dollars….
On the even of the FOMC confab, the forex crowd seems inclined to give the Fed the benefit of the doubt. The dollar rose sharply today against major currencies. The threat of another hike in Fed funds will do that. But the after-effects of a 25-basis-point rise in interest rates, as is widely expected, doesn’t carry much staying power. But that’s a worry for another day. Today, on the other hand, was all about optimism. “We’re getting closer to the point where yields are giving the dollar some benefit,” Robert Rennie, a currency strategist at Westpac Banking Group in Sydney, Australia, tells Bloomberg News. “It doesn’t make sense to be selling the dollar ahead of the Fed meeting.”
Fair enough. But inquiring minds want to know, what makes sense after the Fed meeting?