Recession Watch: Oil, Inflation, the Fed

Here's what policymakers, economists, and strategists have to say about the impact of $133 oil on inflation, growth, and Fed policy

Oil prices reached nosebleed territory on May 21, moving above $133 per barrel in New York trading—on the same day that Federal Reserve officials expressed growing concern about inflation. Here's a roundup of what policymakers, economists, and strategists had to say about oil, inflation, growth, and interest rates on May 21, as compiled by, S&P MarketScope, and Action Economics:

The Fed's Inflation Worries

From Action Economics: The minutes from the Apr. 29-30 Federal Reserve policy meeting showed the expected upward shift in inflation expectations and unemployment, while the Fed downgraded its outlook on growth. Most officials viewed the April rate cut as a "close call," and several members noted "it was unlikely to be appropriate to ease policy in response to information suggesting that the economy was slowing further, or even contracting in the near term" (but that was already suggested by the dissents from Philadelphia Fed President Charles Plosser and Dallas Fed President Richard Fisher).

It was still the case that "most" members still saw downside risks to growth, with "many" officials expecting a contraction in gross domestic product in the first half of the year. However, a rebound was expected in the second half of the year and in 2009.

The minutes are consistent with the view the Fed is on hold for now, but didn't suggest rate hikes are in the picture at all.

Warsh Suggests the Fed Is on Hold

From S&P MarketScope: Fed Governor Kevin Warsh warned that the policy-setting Federal Open Market Committee has used its traditional blunt tool or "hammer" of rate cuts with considerable force over the past nine months and it needs to resist the impulse to bang rates down again. "Even if the economy were to weaken somewhat further, we should be inclined to resist expected, reflexive calls to trot out the hammer again," he said in prepared remarks to the Exchequer Club in Washington. Instead, the Fed needs to reinforce the idea that "further hammering needs to be done, but it needs to be accomplished by the financial institutions themselves in retooling their businesses," Warsh said. That includes raising substantial capital, changing business models, and other efforts to improve financial market functioning.

"If the Fed were deemed too accommodative for too long, credibility could be undermined," Warsh said. "The public could mistakenly see the stance of policy as a sign that our commitment to long-term price stability has wavered. That is not a perception we will countenance," he said. "If abundant credit availability is perpetuated by investor overconfidence, I would submit, policymakers may need to target a higher federal funds rate than otherwise to help the economy attain a sustainable equilibrium. The changes of credit availability during the past six years have less to do with the prevailing stance of policy and more to do with changes in financial markets and financial intermediaries," he said.

A Rate Cut Not Expected This Cycle

From John Ryding, chief U.S. economist, Bear Stearns (BSC): The last Fed rate cut was a "close call" and the Fed appears to be increasingly concerned about the inflation outlook. Since the last meeting, core PPI and import price inflation rates have hit new highs, and the University of Michigan's five-year inflation expectations index has risen to a 12-year high of 3.3%. In addition, oil prices are over $132 per barrel ($20 per barrel higher than they were at the time of this FOMC meeting). It seems unlikely to us that the funds rate will be cut again in this rates cycle.

Oil Prices and Tax Rebates

From Tony Crescenzi, chief bond market strategist, Miller Tabak: At 11 a.m., Bloomberg posted a headline noting the price of a barrel of crude oil had leaped above $131 a barrel. Three minutes later there was another alert when oil crossed $132. The rapid increases are numbing, and they are eating increasingly into the $130 billion tax rebates being sent to consumers. An additional $30 billion or so of stimulus is expected to be reaped by businesses in the form of accelerated depreciation and bonuses for the purchase of new equipment.

Unfortunately, this sizable stimulus is in peril of being completely engulfed by the recent rise in energy costs. When the Stimulus Act was signed on Feb. 13, crude oil closed at $93.29 a barrel. It has since climbed by $40. Given that the U.S. consumes roughly 20.5 million barrels per day, this means that if recent price increases are sustained, the cost of energy to U.S. consumers will increase by about $300 billion over the next 12 months. The actual toll will be smaller than that, given that some of the extra oil expenditure will be recorded as revenue by U.S. entities and because shareholders in U.S. energy companies are reaping benefits, but the fact remains that the tax-rebate checks won't go as far as they would have.

Oil: Too Far Too Fast?

From Action Economics: A reasonable case can be made arguing that the market has become frothy and the doubling in prices in little over a year will inevitably erode demand. Also, the recent market frenzy, a good proportion of which has been driven by speculative accounts, seemingly belies supply developments: Saudi Arabia has been pumping an extra 300,000 barrels per day (bpd) since May 10 and is planning to maintain production levels through the next month; Iraqi oil production is set to rise by at least 125,000 bpd in June; the U.S. government last week approved legislation to stop refilling the U.S. emergency stockpile until crude prices fall below $75 a barrel, a measure that will add around 75,000 bpd (according to Reuters). Recent bullish forecasts may have stolen the limelight, but that would be typical in any market that has been experiencing a strong bull trend and, despite the secular growth in demand [from emerging economies], it doesn't seem too outlandish to suggest that the market may be getting ahead of itself.

Stagflation Has Become a Reality

From Joachim Fels, chief global fixed income economist, Morgan Stanley (MS): What was still a threat six months ago has become reality in the U.S. and is likely to arrive in Europe soon: stagflation, defined as a period of weak or no growth and unusually high inflation. The underlying reason for persistent inflation pressures is a very lax global monetary policy stance. Central banks around the world are fueling and accommodating the surge in food and energy prices. Spillover into other prices will follow. We find many important parallels between the stagflationary 1970s and today. History won't repeat itself, but it rhymes.

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