Oiling the economic squeaky wheel

By Michael Coote

Friday 24th September 2004

The good oil on oil was given by Edward Gramlich, governor of the Federal Reserve Bank of Kansas City, Missouri, at the Kansas City annual economic luncheon last week.

To judge by the Federal Reserve's press releases, its governors are social butterflies disporting themselves about a giddy social whirl of gourmandising. Apparently the only time they don't sing for their supper is at the dry old party of reporting to the US Congress.

Oil's price explosion has given the Fed a headache at a time when it is trying to move US interest rates back toward normal levels. Now the Fed has two problems to manage instead of one.

It has to raise interest rates in a manner that does not disrupt the economy, while at the same time preventing the oil shock from changing from a temporary to a permanent stimulus to domestic inflation.

Gramlich outlined the two key constraints of Fed monetary policy and how these relate to oil shocks: "Monetary policy makers in this country have a dual mandate to stabilise prices and to maximise sustainable employment in the long run. Their response to oil price increases should focus on these two objectives."

And therein lies the rub for the Fed. It has to manage interest rates in such a way as to fit the impact of their level somewhere within the spectrum of letting inflation run or tipping people out of work. Some sort of trade-off or compromise becomes necessary.

When there is an oil shock, the problem becomes more difficult in judging how much to concede to either inflation or unemployment, especially when the shock hits an economy that is not in interest rate equilibrium but which has undergone three and a half years of economic stimulus independently needing correction.

Gramlich tried to put a brave face on things, for example pointing to evidence that the present oil shock is probably temporary, definitely likely to be mitigated in its inflationary effects and stating "even the present high real price of oil is only about half the real price in 1980, and the importance of energy in the overall economy is also less than half what it was then."

Moreover, the shock is academically interesting because it is the first one caused by demand from the likes of the US, China and India whereas previous specimens have been supply-driven as Opec nations have hiked prices. But there is no doubt the Fed is worried and he made a comment of note for investors.

"Without the oil shock, policymakers beginning from a period of low interest rates would try to keep the economy on an even growth path as they gradually raised nominal interest rates.

"With the shocks, nominal rates would still likely follow an upward path, though the economic reactions would be bumpier, with temporary rises in both inflation and unemployment."

There are implications for bond markets and sharemarkets in what Gramlich said. Bond yields will need to rise to compensate for the inflationary impact of oil's price increase.

Share prices will dither around while investors fret over the consequences of higher unemployment and lower household income. It will be a lot more difficult to move investment markets back toward their normal alignments with each other.

What Gramlich's comments suggest is that 2005 could be another year like 2004, in which bond and share indices have meandered about in tight trading ranges. The monetary policy adjustments spoken of by the Kansas City Fed governor will, after all, take place over the balance of this year and across the next.

And despite the temporary nature of the present oil spike, as the Fed's own graph shows, the long-term futures market is telling us that the betting is for a sustained increase in the price of oil, and that has knock-on effects to demand and prices for alternative energy sources.

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