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Fed Watchers Look to the Oil Patch

By Michael Wallace As the Middle East crisis simmers and the situation in Venezuela remains uncertain after President Hugo Chavez was ousted and reinstalled in the space of a weekend, the oil-price outlook is nothing if not volatile. The recent surge in prices -- fanned by the Israeli-Palestinian crisis and tightening global crude supplies -- has certainly generated a great deal of analysis of the economic implications, especially the risks to growth and price stability. But one key trend has been somewhat overlooked: In the aggregate, commodity prices actually have been relatively tame.

The March producer price index and retail sales data, released on Apr. 12, clearly showed one-off distortions due to the recent oil-prices peak. The overall PPI surged 1%, but it gained only 0.1% when stripped of food and energy costs. Similarly, the paltry 0.2% gain in retail sales was thanks mostly to a price-induced 3.8% hike in gas station sales. Each report illustrates the singular and illusory effects of the spike in oil prices, which may be quickly reversed ahead -- leaving the Federal Reserve in a relatively comfortable position with regard to inflation.

With Secretary of State Colin Powell in Jerusalem, any resolution or easing of tensions in the Mideast could prompt oil prices to fall again when energy-market players finally unwind their speculative bets. True, a broadening Mideast conflict -- and any sustained gains in energy prices as a result -- are still a risk to Fed policymakers.

COMMON INTEREST. However, in the near-term, the Fed is likely to exercise restraint with respect to interest-rate hikes while the U.S. economy is on the mend. (Standard & Poor's does not expect the Fed to take any action on rates until its Aug. 13 policy meeting, when we expect a 25-basis-point tightening in the benchmark federal funds rate.)

While the most recent developments in the West Bank have raised the stakes, the vast majority of players in the Persian Gulf drama share a common interest in containing and ending the immediate conflict. Swing producers Russia and Saudi Arabia -- who have the means to make up any shortfall in supply -- have remained committed to their stabilizing role and are ignoring Iraqi calls for others to follow its export ban.

There's enough confidence in a stable oil supply that OPEC Secretary General Rodriguez said the cartel would not make up for temporary supply disruptions from Iraq and Venezuela for fear that "we could suffer a [price] collapse after the resolution of these conflicts."

RISK-AVERSE. The Mideast-fueled price spike, while dramatic, has really only allowed oil prices to return to pre-September 11 levels. In fact, crude prices are still some 16% below year-ago levels and nearly 40% below their peak reached in the fall of 2000. Energy analysts have been warning that speculation has played a key role in the run-up in oil prices since the Israeli offensive began -- and profit-taking could well exaggerate energy-market losses ahead.

Oil appears overbought when one considers the signals from other market benchmarks. The Commodity Research Bureau index -- which tracks the prices of a basket of key commodities -- has continued its one-month losing streak at below 200 since the recent high of 208.39 on Apr. 2 and is some 17% below its peak in October, 2000. The Journal of Commerce index of industrial commodities has been able to hold near April highs of 80. Thanks largely to oil, it's up some 11% from November lows of 71.22. But it remains 14% below its cycle peak of 92.1 in September, 2000.

Meanwhile, investors continue to be risk-averse as doubts begin to stir about the strength and durability of the U.S. recovery (witness the Street's negative reaction to recent warnings by the likes of IBM and Siebel). This is important, since a recovery in global oil demand was predicated on the recovery of global growth and a profits rebound critical for business spending and job growth.

PATIENT STANCE. Subsiding hostilities and cheaper commodities will help keep a lid on inflation -- and leave the Fed's policy window open slightly as the economy faces the lower risk of a flare-up in inflation. On the flip side, if events in Israel boil over, the Fed will be equally remiss in rushing a policy tightening, given the risk of damage to the economic recovery. Either outcome, then, will give the Fed one more excuse to delay its eventual tightening.

Still, the day will come when the Fed brings the benchmark federal funds rate back in line with pre-September levels of 3.5%, though it may not be in a rush to push real rates -- as adjusted for inflation -- up very far. The Fed's reluctance in the near-term is borne out by its U.S. macroeconometric model, a tool the Fed has created to gauge and illustrate the effects of external shocks on key economic variables. This simulation helps Greenspan & Co. formulate the desired policy response.

One current model predicts that a sustained (four-quarter) $10-per-barrel increase in oil prices would knock 0.2% off real gross domestic product growth through the implied tax on consumers. The model also shows that such a price spike would boost inflation, as measured by the consumer price index, by 0.5% in the first year.

It may turn out that the Fed's patient policy stance will prove inflationary and result in a steeper yield curve, with a wide divergence between short- and long-term interest rates. Meantime, productivity, geopolitics, and the economy will determine if the Fed gets the mix about right. For now, it's increasingly clear the Fed is in no hurry to ratchet rates higher. Wallace is chief market strategist for Standard & Poor's/MMS International

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