Thanks Russ.
I am posting this commentary from the link you provided.
MBA Economic Commentary
Issue #116 – June 2004
Rising Energy Prices: A Quandary for the Fed
June 14, 2004
The economy continues to grow at a solid pace. Real GDP growth in the first quarter was revised up to a 4.4 percent annual rate, largely on the strength of an upward revision in the level of inventory investment. Corporate profits rose again in the first quarter, but less than in the fourth. Still, the first-quarter level of economic profits was 32 percent above a year earlier, as businesses continue to gain the lion's share of the benefits of strong productivity gains.
Logically, higher inventory investment in the first quarter should mean a smaller contribution to growth from that sector in the second quarter. Currently available data suggest, however, that GDP growth is continuing at a pace close to, or more likely above, the first-quarter rate. Payroll employment increased 248,000 in May, following (revised) increases of roughly 350,000 a month in March and April. Manufacturing output in April increased 0.7 percent, and the jump in aggregate hours worked in manufacturing in May suggests a substantially larger rise in May. The construction report for April also brought good news: the dollar volume of construction put-in-place rose 1.3 percent that month, following an upward revised 2.4 percent increase in March.
Some of the incoming data, however, hint at the possibility of a bit of softening in the economy's forward progress. Orders for durable goods declined in April-but that came after a large March increase. Initial claims for unemployment insurance have flattened out in recent weeks, but at levels well below those of just a few months ago. Consumer spending has clearly moderated: in the first four months of this year, consumer spending in constant dollars rose at an annual rate of 2.7 percent, compared with an increase of 4.0 percent over the 12 months ended in December. The weakness has been most pronounced in expenditures for durable goods. Auto sales were up in May, however, and chain-store sales apparently were robust last month.
The largest question mark regarding the economy's future may well be the reaction to rising prices of energy. With OPEC raising quotas, crude oil prices may have passed their peak. But with refinery capacity limited, inventories low, and the peak driving season just ahead, a near-term decline in gasoline prices seems unlikely. And with world demand boosted by a reviving global economy, prices of petroleum products may remain at lofty levels for the foreseeable future.
In April, energy prices in the consumer price index (CPI) were 5.5 percent above a year earlier and 19 percent above two years earlier. That toll will surely increase considerably further as the numbers for May and June become available. Headline inflation has reflected those increases: in the last 3 months, the annual rate of CPI inflation was 3.9 percent, compared with 2.3 percent during the past 12 months. Has the rise in energy prices begun to spill over into the core CPI inflation rate, which itself has turned up considerably? Possibly, but that is not clear, because there are other factors that could account for most of the upturn in core inflation-such as the fall in the dollar's value in exchange markets and the increase in business pricing power. The greatest danger of a supply side shock spilling over into core inflation is when the shock triggers a rise in wage costs. Until quite recently, the rise in average hourly earnings was continuing to moderate. In the past several months, however, the rise of average earnings per hour has begun to move up a bit; over the past 3 months, this measure of wages registered an increase of 3.1 percent at an annual rate.
Higher energy prices act like a tax on consumers, and through that route tend to slow consumer spending and economic growth. Over the two years ending in the first quarter, the annual rate of consumer expenditures for energy products rose $91.5 billion. Virtually all of that increase reflected higher prices, and the toll will undoubtedly be higher in the second quarter. With disposable income running around $8-1/2 trillion, the "energy tax" is now roughly 1 percent of after-tax incomes and rising. To date, the impact of the rising energy tax on disposable income and consumer spending has been offset by income tax reductions. But the effect of those tax reductions on consumer expenditures by now has largely run its course; the consequence, therefore, is likely to be a slower pace of consumer spending going forward than the year-over-year rise of 4.3 percent registered in the first quarter.
The energy tax on consumers is not apt to be a fatal blow to the expansion. Job gains have picked up substantially and are supplying consumers with stronger increases in wage and salary incomes. But in this month's forecast, we have trimmed slightly the expected growth rates of consumer buying and real GDP in the latter half of this year and on into 2005 in response to higher energy prices. We now expect GDP growth of about 3-3/4 percent at an annual rate in the second half of the year and continuing at close to that pace in 2005.
What to do about the rise in energy prices will probably be a central topic of discussion when the Federal Reserve meets to discuss its policy options later this month. One obvious concern is that, if the economy were to continue to grow strongly, the dangers would increase of a spillover of high and rising energy prices into core inflation. The other concern is that the energy price run-up may take a more severe toll on economic growth than can be presently foreseen. The principal channel would be the energy tax on consumers, but the impact of rising costs on businesses that are energy intensive could lead to postponement or cancellation of business investment spending. The Fed thus will find itself-as is always the case in a supply-side price shock-in a dilemma. The inflation threat would seem to call for a tighter monetary policy, but the negative impact on growth for a looser one.
We believe the Fed will resolve the dilemma, for the time being at least, by sticking to the plan for the measured pace of removing policy accommodation announced following the May 4 Federal Open Market Committee meeting. As measured by the Fed's preferred measure of inflation, the core component of the chain price index for personal consumption expenditures, inflation is still below 2 percent, and presumably, therefore, still within the Fed's comfort zone. With substantial slack still prevailing in labor markets and productivity rising robustly, there is no need for the Fed to hit the panic button. Still, with many of the inflation numbers looking more worrisome, the prospects of a slowdown in growth still problematic, and a widespread belief in financial markets that the Fed is "behind the curve," the Fed cannot afford simply to sit on its hands. The best guess is that the funds rate will be increased by one-quarter percentage point at the policy meeting on June 30, and another quarter point move at the August 10 and September 21 meetings. Then, we expect the Fed to pause and assess the impact of its actions before beginning to increase rates again later this year and on into 2005.
Eventually, the Fed will have to raise the federal funds rate to a neutral position-a rate in real terms of around 2-1/2 to 3 percent--to remove policy accommodation altogether. At today's inflation rate, that would imply a nominal federal funds rate of 4 to 5 percent. If the Fed is able to stay for an extended period with a measured pace of removing policy accommodation, a neutral federal funds rate may not be achieved before 2006 or conceivably even later. That is what our forecast assumes. We recognize, however, that uncertainties with regard to forecasts and judgments about policy changes increase exponentially with the passage of time. And the case for a more aggressive course of removing policy accommodation will gain strength if the economy continues to grow as rapidly as it has in recent months.
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