Brad DeLong's Semi-Daily Journal (2004)

If higher inflation is transitory because of oil,
and oil prices are high because of inadequate supply rather than a "risk premium" how do you get oil prices to go back down without a drop in demand and about the only way to do that is a very significant weakening of the economy.

The Fed position seem to have some elements that are inconsisent with each other or represent
hope more than analysis.

I think that the Fed was in a corner.

Until the crappy job numbers, it was a dead nut cinch, and if they didn't increase the rate, the markets would have flipped out screaming, "Greenspan says that the sky is falling!"

Can anyone say stagflation? Gring it on Alan.

The other consideration that applies is that the Fed has been in an accommodative position for a very long time, with the attendant impact on liquidity. Some of the committee have to be uncomfortable with this.

BTW, I'm getting really tired of the phrase "going forward." The Fed should be more elegant than this.

Jim -- with money supply growth and monetary base growth slowing sharply, difficult y/y comparisons for free reseves, and the stock market down significantly over the past few weeks are you sure that liquidity mis positive?

My reading is that the Fed wants to raise rates slowly and incrementally rather than making a big jump later.

"Monetary policy remains accomodative" My take is that the Fed believes that raising a quarter point will not adversely affect the economy. Quite frankly, I don't think there is a big difference in a 1% or 2% rate given the amount of investment capital still on the sidelines. Going from 1.25 to 1.5 in my view is a relatively neutral step for the economy and serves to correct some of the dislocations caused by interest rates that are too low.

"At [the current] rate of trend productivity growth, we need real GDP growth of 4% per year to keep the labor market from worsening--and faster real GDP growth to improve the state of the labor market."

Slowing the growth rate with increasing interest rates means the Federal Reserve has opted to allow the tough labor market conditions to continue. The worry appears to be energy prices and resulting inflation, but the Fed tells us the problem of rising energy prices is temporary. What gives?

Given where we are, a huge structural budget deficit, massive public debt overhang, a war, slow economy at home inflation looks like a no-brainer consequence to me.

For a lot of people who are racked up to their eyes in a fixed rate mortgage inflation is probably a pretty attractive proposition.

I think it is pretty clear that if Bush is elected in November a currency crisis will follow shortly after. You can't continue banana republic policies forever.

From my perspective have had a very defensive portfolio strategy all year and am telling clients I see no reason to change that.
Would need much weaker economy for that to happen.

The FOMC press release attributes the recent slowdown in output and job growth to higher oil prices. This is an interesting conclusion to reach, given that oil prices have been climbing for a couple of years. Is there a magic number for oil prices? (I don’t like magic numbers.) Is it the acceleration in oil prices that is the problem? As I understand it, rapid changes in oil price do tend to magnify the impact of the price level on economic performance.

Given the persistence in oil price gains, the notion that higher oil prices are transitory is pretty optimistic. Higher oil prices, if not transitory, will mean slower growth and higher inflation. Growth will slow because potential growth is lower when oil prices are high. Trying to lift growth that has slowed because of the oil price level would mean accommodating inflation (the Fed may be able to do something about the short-term impact of the change in oil prices). So while the Fed is making a brave show for now (as MS suggests), if oil prices remain elevated, then the Fed will have reason to lower its expectation of trend growth, raise its expectation of inflation, maybe adjust upward its notion of what a neutral funds rate would be.

I don’t mean to sit the fence, but I think Jim is right, and spencer is right. Financial conditions are less favorable now than at the beginning of the year, and M2 growth has slumped. That need not prevent some Fed officials from being worried that they have been too generous for too long.

Anne, does monetary policy have more than a limited effect in the 1% to 2% range? If there was little stimulus going from 2% to 1% is there much brake going from 1% back to 2%?

As for capital, it can be invested in labor, or it can be invested in technology to replace labor. In any case, where is the evidence that our low employment is being driven by lack of available low cost capital?

If the small increase by the Fed has a minimal effect, is the Fed decision really to allow "tough labor market conditions to continue"? Does addressing the labor market requires a fiscal policy fix, not monetary policy?

Spencer

Why would you be bolder in portfolio allocation if the economy were weaker? Also, why do you think the price earning ratio for the S&P is still above 18 more than 4 1/2 years after the bear market began?

Bakho

Bond investors try to anticipate the Fed. The 10 years treasury yield has risen from 3.1% to 4.3% in 14 months and is likely to go higher if the economy simply grows moderately. Moves by the Fed are minor in themselves, but the Fed direction is magnified by bond traders. The fiscal stimulus from the tax cuts and quickening of government speanding is slowing, so I do not wish higher interest rates to add to the slowing.

There are some talks about higher oil prices being caused partly by hedge funds looking for quick returns buying oil futures. If that is really a factor, then higher fed funds rates may help to lower oil prices without slowing down the economy too much -- just a bit less money chasing around for returns may do wonder for oil prices. Is this a possibility?

KHarris

I would like to argue, for labor market conditions trouble me, but as usual you make a convincing case. Oil prices are likely to stay near 40 dollars a barrel and interest rates will continue to rise unless growth slowly significantly. We have a shrp labor market problem.

http://www.nytimes.com/2004/08/05/business/05oil.html

"Speculators don't set the price, but they intensify a price movement in either direction, beyond or below what the fundamentals warrant," said James Burkhard, director of oil market analysis at Cambridge Energy Research Associates. "So far, they've intensified this increase."

Much of the increased speculation has come from hedge funds, which continued to attract billions of dollars in fresh capital from wealthy investors. Some $38.1 billion flowed into hedge funds in the first quarter of this year, according to Tremont Capital Management. Of that amount, Tremont's figures show, some $5.5 billion went to macro funds, which try to profit from speculating on broad global trends and geopolitical disruptions; another $3.9 billion went into funds specializing in futures. Both types are likely to be betting on oil price movements using options and futures contracts.

"As more money moved into hedge funds, it has driven fund managers to look at oil, because there is only so much interest-rate position you can take," said David Kitson, head of global energy at J. P. Morgan in London.

Traders and analysts estimate that about 200 hedge funds now have significant positions in the energy markets. They said that some pension funds have recently become avid investors in oil futures.

The flood of new entrants to the market has prompted some concerns, because investing in futures markets can be exponentially riskier than investing in equities. "This is not for widows and orphans," said Peter Beutel, president of Cameron Hanover, an energy-risk management firm in New Canaan, Conn. "Commodity prices move very quickly."

Or is the Fed worried about the dollar? They're not supposed to be, but come on...

Anne, 14 months ago, the Fed was at 1.25%, right where we were yesterday. Long term bond rates increased independent of the Fed. Sure there is a reaction, but is the Fed following the curve and not leading it?

Is a shortage of capital causing employment shortfalls? We still have slack demand and that is far more responsive to a 50% increase in gasoline prices than a 0.25 point increase by the Fed. How much increase in interest payments will people see because of this change? How much will be offset by increased interest payments on CDs held by the elderly?

Bakho

Well, I agree in general. The Fed increase in itself, will little slow the economy. Still, I do not like the direction or the prospect of moderate inflation sluggish growth period. However, what shortage of capital are you referring to?

Anne,

Thanks for the facts! Looks like there is at least a possibility that oil prices may collaps in a few months if global demand slows and Yukos facilities resume production after being sliced and allocated to someone Putin likes? Although then we may have to worry about another financial market crisis if too many hedge funds or pension funds lose money in this game ...

Russia may have learned to play the energy game all too well. Withhold production from the markets at key points and make more from the price increases than is losi in lower volume. This is not a promising energy market.

Oh dear, Anne is saying that Russia is the new Enron, using a manufactured legal crisis to slow production from Yukos while markets are tight and it will increase profits for them?

That would be great.

My conclusion from the posts here (I am trying to find a consensus) is that the Fed figures it can't do much about the job market anyway with interest rates, and that if pushing the string has done little, pulling it back again won't do much either. So it raised the rates just a little to have an effect in an arena where it probably have more effect (on potential inflation if oil prices are high).

That is what I get from you folks. What is my grade?

Anne,
I was not referring to a shortage of capital for investment. My question was , "Is the amount of investment capital currently available an impediment to hiring?" If there is excess capital, then tightening the money supply will have minimal effect on hiring. If the current hiring slump is due to high productivity and a slump in demand for products and services then you could make an argument that a rate hike will decrease demand. Will an increase in interest rates from 1.25 to 1.5 decrease demand? If not, the effect on hiring will be negligible.

Anne: "Slowing the growth rate with increasing interest rates means the Federal Reserve has opted to allow the tough labor market conditions to continue."

From my amateur vantage point, I'm afraid the Fed cannot do a lot to improve the labor market beyond tough conditions. If they let loose, the new money will go into assets and price hikes pronto. Is this not what has happened to date?

Surely the thing to do now is to break the fever in the oil market, rather than farting around with tightening. Why not threats to open the petroleum reserve, new conservation initiatives, etc. But with the Al Qaeda recruitment drive being conducted in Iraq, maybe all of this would be ineffectual.

>I'm getting really tired of the phrase "going forward." The Fed should be more elegant than this.<

Jim Harris, you are my hero!

the oil market is being driven by chinese fuel oil demand because of the massive shortfall in electricity generation capacity (40MW close to 10% of the total in the summer). There will be little fuel oil demand in the winter (it is not used for heating). As a result oil is now probably now more demand in the summer months than in the winter. On top of this there has been a lot of overstocking, similar to what we saw in soybeans last year.

If oil prices were easy to forecast, we wouldn't be having this discussion. Investment by the majors in exploration and pushing pipe into new fields is, if I read the press correctly, very slow relative to the level of prices in recent quarters. Majors have prefered to buy up known reserves rather than look for new oil. There is lots of talk that prove reserves have now peaked - forever. Longer-dated futures prices have shifted up gradually, but steadily along with spot crude (6-year prices now in the mid-$30/bbl range, I think), suggesting expectation of higher prices for years to come. Of course, futures prices may simply be reflecting the magitude and duration of increase in spot crude prices - investors in long-dated futures may know more about their own need for oil than about likely future conditions in the oil market.

US crude oil inventories (API data) are up something like 4.6% from this time last year, but this time last year, they were rather low. Inventory behavior in the oil sector has changed enough in recent years that just by looking, I don't know if that 4.6% rise is enough to call current reserves sufficient.