With Oil Speculators Blitzing, the Fed Needs to Call an Interest-Rate Reverse Play
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The inflationary reality that we as consumers have been living for months may finally be starting to dawn on the U.S. Federal Reserve.
The minutes of the last policymaking Federal Open Market Committee (FOMC) meeting, released on Wednesday, showed that the Fed’s inflation forecast was raised from a range of 2.1%-2.4% to a range of 3.1%-3.4%.
Add the zooming oil prices we have seen recently into the mix, and the conclusion is inevitable: The nation’s central bank will soon have to reverse course and start raising interest rates - and probably in a hurry, too, if the Fed wants to keep oil prices on this side of the stratosphere.
That’s no small shift: After all, for nearly eight months the central bank has been mounting one of the most aggressive rate-cutting campaigns on record, slashing the benchmark Federal Funds rate from 5.25% down to 2.0%.
The Key Catalysts
Several factors have made it imperative that rates head higher. Let’s take inflation first. The consumer price index (CPI) figures for the last couple of months actually have been encouraging for the market. CPI has been coming in lower than analysts had expected. However, in both March and April, the downward seasonal adjustment was huge, far above the average adjustment for the past 10 years.
Thus, in March, a price increase of 0.9% (equivalent to 11.1% per annum) was revised down by the magic of seasonal adjustment to a mere 0.3%. Similarly, in April, an unadjusted 0.6% figure was seasonally adjusted down to just 0.2%.
It doesn’t require a super suspicious person to find that odd, especially during a period in which everyone’s worried about inflation. If the average March and April seasonal adjustment for 1998-2007 had been applied to the unadjusted figures, the annual rate of inflation for March and April would have been above 7%, instead of the 3.1% officially reported.
In any case, the producer price index (PPI) inflation is running at 6.5%, which suggests the CPI figure could experience an uptick very soon.
Either way, if the Fed thinks inflation will be above 3%, and the monthly figures come in above that number - let alone as high as 6%-7% - it won’t be able to keep the Fed Funds rate at its current 2.0% for long. The FOMC knows quite well that a Fed Funds rate lower than the current inflation rate will only serve to fuel inflationary pressures, and force the inflation rate even higher. If the Fed thought inflation was at 2%, it could justify keeping the Federal Funds rate at 2%; but now that the FOMC has acknowledged that it thinks inflation will be above 3%, it’s difficult to justify such a low Federal Funds target - something around 3%-3.5% seems more plausible, even if the United States is fighting a recession.
If monthly inflation numbers were all the Fed was worried about, we could expect the central bank to gradually ratchet the Fed Funds rate up to about 3% - or perhaps even a little bit higher. This deft initiative might get under way at the FOMC’s June 24-25 meeting, or might start at its Aug. 5 meeting, but either way, short-term rates would reach 3% by the end of this year, unless the banking system suffered another real disaster before then.
However, the oil markets have given the Fed something else to worry about.
Oil prices at $133 per barrel last Wednesday were up 60% from the $83 per barrel level on Sept. 18, 2007, the day the Fed began easing cycle for interest rates [oil prices punched through the $135-per-barrel level on Thursday before sliding back]. Other commodity prices have also gone through the roof during that same period. While U.S. monetary policy isn’t the only thing affecting global oil prices, which are dollar-denominated, it’s pretty clear that the Fed rate cuts and the central bank’s creation of money through bailing out the banking system have made an awful lot of money available for oil speculators.
And while hedge funds and sovereign wealth funds are reaping these massive windfalls, don’t forget the flipside of this equation …
This pricing petro-gusher is costing the United States real money.
The Suicide Squeeze Play
Since the United States currently imports about 9.4 million barrels per day, the $50 price increase since September has cost the United States $470 million a day. That’s $170 billion per annum, more than 1% of gross domestic product (GDP), or 22% of the current U.S. balance of payments deficit.
T. Boone Pickens, the octogenarian Texas oil legend, has emerged with a prediction that the price of oil could reach $150 a barrel by the end of the year. He points out that the world oil supply is currently at a maximum of 85 million barrels per day, while demand is 87 million.
There’s just one problem. There’s no way this supply shortfall of just 2 million barrels per day, or 2.3%, should cause oil prices to soar 60% in eight months - let alone another 15% before year-end as Pickens predicts. Rising prices should reduce demand and (to a lesser extent) increase supply. Economists differ by how much, but no economist I know of thinks the price elasticity of oil is below 10%: And at 10% elasticity, a 2.4% supply shortfall should push the price up 24%, not 60%.
So where does the other 36% come from - not to mention the additional price increases that Pickens is predicting?
It must be “artificial” - that is, created by speculators.
With U.S. interest rates below the inflation rate, betting that oil prices will go up is like shooting fish in a barrel - you can’t miss, provided only that you and your friends are together rich enough to control the market. And with all the extra money that the Fed has created just sloshing around, speculators are nothing, if not rich.
How do you stop speculators? You whack them with a two-by-four, that’s how. You get their attention with a shock move. You bring them pain by increasing their financing cost, you insert in their mind the idea that you might really mean it, and underscore that you might go on attacking them until their speculative run-up in oil prices is ended.
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Tags: , Consumer Price Index, CPI, energy, fed, Federal Open Market Committee, Federal Reserve, FNM, Fomc, FRE, Gdp, inflation, oil, Oil Prices, Oil Speculators, PPI, Ppi Inflation, Rate Of Inflation, RYJCXAbout the Author
Martin O. Hutchinson is a Contributing Editor to both the Money Map Report and Money Morning. An investment banker with more than 25 years experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets.
Hutchinson earned his undergraduate degree in mathematics from Cambridge University, and an MBA from Harvard University. He lives near Washington, D.C.
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