6/16/99 - OPINION: If Federal Reserve Tightens, Blame OPEC
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Jun. 16 (Bridge News)--From an analysis by Lawrence Kudlow, chief economist of American Skandia
SHELTON, Conn.--Oil, money and interest rates have historically been an inflammable mix. Not even today"s new era information economy is immune from the oil factor.
An unexpected oil price shock has driven U.S. Treasury bond rates significantly higher this year, halting the stock market advance.
Most Federal Reserve watchers now believe the central bank"s overnight policy rate will be raised a quarter point at the June 30 meeting of the Federal Open Market Committee. Futures markets have priced in a second Fed snugging in the fourth quarter.
Economists will be forced back to their drawing boards in order to revise down their growth forecasts in the wake of higher oil prices.
Life is full of surprises. Two years ago it was the Asian collapse. Last year was the Russian meltdown. This year it"s oil. Forecasting is an exercise in humility.
It is especially noteworthy that most forecasters are saying an "overheated" economy is the chief culprit behind this year"s interest rate rise and related flare-up of inflation fears.
Hauling out their Phillips curves--which incorrectly posit an inverse trade-off between falling unemployment and rising inflation--mainstream economists in and outside the Fed are singing a familiar tune: Growth must be slowed lest inflation rise.
They say a 4.2 percent jobless rate is way below the so-called non- accelerating inflation rate of unemployment, or NAIRU, despite the fact that both unemployment and inflation have been falling together for years.
Bond traders seem to hate jobs--except, of course, their own. In this limits-to-growth Malthusian model of pessimism, more people working and prospering is a bad thing. Tch, tch. No wonder economics is called the dismal science.
Notwithstanding the Keynesian chorus, I believe that the Organization of Petroleum Exporting Countries" rigging of higher oil prices is mainly responsible for rising rates, not the healthy economy.
Just look at recent history. In 1997, oil averaged $20.60 per barrel, with Treasury yields hovering close to 7 percent. Last year, however, oil dropped 29 percent to a calendar average of $14.40.
Right on cue, the 30-year Treasury bond dropped roughly a third to less than 5 percent.
Today, with oil ranging close to $18 per barrel, a 25 percent price hike over 1998, rates on the 30-year "long" bond are approaching 6 1/4 percent, about the same magnitude of gain as oil.
Coincidence? I don"t think so. Temporary oil shocks have always affected interest rates and the economy.
Last year, for example, the economy surged from only 1.8 percent growth in the spring quarter to 6 percent in the autumn period as oil prices declined sharply.
Nearly everyone was fretting about deflationary recession imported from Asia and Russia, but slumping oil and falling interest rates actually generated a highly stimulative tax-cut effect that lowered inflation and raised growth.
The 1998 experience was the mirror image of the 1970s, when a quadrupling of oil prices led to stagflation and sky-high interest rates. The stock market lost nearly two-thirds of its real value.
Importantly, though, misguided Federal Reserve policies during those years of malaise aided and abetted the economic decline. In a mistaken attempt to offset the contractionary nature of the big oil shock in the "70s, the Fed under Arthur Burns and G. William Miller pumped in more and more money.
Gold and other commodities soared, while the dollar slumped. This easy-money accommodation succeeded in turning a temporary inflation of oil into a decade-long inflation of all goods and services.
Higher inflation amounted to a huge tax hike that impoverished the economy by depressing growth, productivity and real wages. (By the way, for you Phillips curvers out there, inflation and unemployment went up together.)
Fed Chairman Alan Greenspan has a good grasp of this history, and this may explain why he is likely to restrain credit a bit this summer. The aim won"t be to prevent growth, but to avoid monetizing higher oil prices into a general inflation increase that could take several years--and a recession--to snuff out.
Incidentally, Greenspan acted similarly in 1990. Despite the onset of recession, the Fed refused to ease policy when the Iraq invasion of Kuwait temporarily drove oil prices to nearly $40 per barrel.
It was this restraint, along with subsequent tightening moves to counter rising commodity prices in 1994, that led to virtually zero inflation and price stability over the past three years.
As for today"s oil problem, it won"t take much from the Fed to limit the inflationary potential, because it"s not much of a problem. We know this because falling precious metals, stable commodity indexes and a strong dollar are all signaling that future inflation over the next year will actually be lower than it is today.
These market-based commodity indicators have a much more accurate inflation-forecasting record than the unemployment rate or the pace of economic growth.
Remember, inflation is caused by a drop in dollar purchasing power, not prosperity. A general increase in all prices, not just oil (or wages), is possible only when money supplied by the Fed is greater than what the markets and the economy demand.
The price of gold, the Bridge/Commodity Research Bureau index and the dollar index are the best measures of "excess money." Think of them as an advance scouting party. They are early warning indicators of monetary overabundance and future inflation.
Right now, these "price rule" signals suggest that money is scarce, not loose. So I don"t have much enthusiasm for a Fed-tightening move.
It"s not the 1970s. The oil hike will be temporary, and a King Dollar- linked gold price of $260 tells me that monetary policy is already tight.
Then again, if new technologies have reduced the cost of producing oil to about $7 per barrel in West Texas and $4 per barrel in the North Sea, even $18 oil can"t last for very long.
OPEC may think it"s in control, but the world market will prove to be the eventual winner. Over time, selling prices will converge with production costs.
Actually, over the past three decades, one ounce of gold, on average, has purchased 20 barrels of oil. So, if gold stays around $260, then oil could drop to $13 per barrel. And that would be consistent with 4 1/2 percent to 5 percent long Treasury rates, as the underlying inflation trend edges below 1 percent.
Capitalizing 3 percent to 5 percent expected corporate profits with a 5 percent discount rate would greatly expand price-earnings multiples and boost the stock market over the next year.
As for the Fed, if it must tighten to offset higher oil--last year it eased when oil dropped--I won"t lose much sleep over it. Call it opportunistic disinflation.
But unnecessary Fed tightening does risk a bigger near-term stock market correction. It would reduce growth over the next year by roughly one-half of a percentage point.
Subtract another 1 percent from growth as business firms complete their investment upgrades to head off problems with the Y2K "millennium bug." Also, incipient recoveries in Europe, Asia and Latin America could be injured.
As to the Y2K presidential race, Vice President Al Gore"s polls would suffer.
LAWRENCE KUDLOW, the chief economist of American Skandia Life Assurance Inc., a Connecticut-based financial services firm, is author of "American Abundance" (Forbes) and worked in the Office of Management and Budget under President Ronald Reagan. His views are not necessarily those of Bridge News, whose ventures include the Internet site www.bridge.com. |
