Jewish World Review Aug. 19, 1999 /7 Elul, 5759
Most Fed watchers now believe the central bankís overnight policy rate will be raised a quarter point at the June 30 FOMC meeting; futures markets have priced in a second Fed snugging in the fourth quarter. Economists will be forced back to their drawing boards in order to revise down their growth forecasts in the wake of higher oil prices.
Life is full of surprises. Two years ago it was the Asian collapse. Last year was the Russian meltdown. This year itís oil. Makes forecasting an exercise in humility.
It is especially noteworthy that most forecasters are blaming an "overheated" economy as the chief culprit behind this yearís interest rate rise and related flare-up of inflation fears. Hauling out their Phillips curves -- which incorrectly posit an inverse trade-off between falling unemployment and rising inflation -- mainstream economists in and outside the Fed are singing a familiar tune: growth must be slowed lest inflation rise.
A 4.2% jobless rate is way below the so-called non-accelerating inflation rate of unemployment (NAIRU), they say, despite the fact that both unemployment and inflation have been falling together for years. Bond traders seem to hate jobs; except, of course, their own. In this limits-to-growth Malthusian model of pessimism more people working and prospering is a bad thing. Tch, tch. No wonder economics is called the dismal science.
Notwithstanding the Keynesian chorus, I believe that OPECís rigging of higher oil prices is mainly responsible for rising rates, not the healthy economy. Just look at recent history. In 1997, oil averaged $20.60 per barrel, with Treasury yields hovering close to 7%. Last year, however, oil dropped 29% to a calendar average of $14.40. Right on cue, the 30-year Treasury bond dropped roughly a third to less than 5%. Today, with oil ranging close to $18 per barrel, a 25% price hike over 1998, long bond rates are approaching 6ľ%, about the same magnitude of gain as oil.
Coincidence? I donít think so. Temporary oil shocks have always affected interest rates and the economy. Last year, for example, the economy surged from only 1.8% growth in the spring quarter to 6% in the autumn period as oil prices declined sharply. Nearly everyone was fretting about deflationary recession imported from Asia and Russia, but slumping oil and falling interest rates actually generated a highly stimulative tax-cut effect that lowered inflation and raised growth.
The 1998 experience was the mirror image reversal of the 1970s, when a quadrupling of oil prices led to stagflation and sky-high interest rates. The stock market lost nearly two-thirds of its real value. Importantly, though, misguided Federal Reserve policies during those years of malaise aided and abetted the economic decline.
In a mistaken attempt to offset the contractionary nature of the big oil shock in the Seventies, the Fed under Arthur Burns and G. William Miller pumped in more and more money. Gold and other commodities soared, while the dollar slumped. This easy-money accommodation succeeded in turning a temporary inflation of oil into a decade-long inflation of all goods and services. Higher inflation amounted to a huge tax hike that impoverished the economy by depressing growth, productivity and real wages. By the way, for you Phillips curvers out there, inflation and unemployment went up together.
Alan Greenspan has a good grasp of this history, and this may explain why he is likely to restrain credit a bit this summer. Not to prevent growth, but to avoid monetizing higher oil prices into a general inflation increase that could take several years -- and a recession -- to snuff out.
Incidentally, Greenspan acted similarly in 1990. Despite the onset of recession, the Fed refused to ease policy when the Iraq invasion of Kuwait temporarily drove oil prices to nearly $40 per barrel. It was this restraint, along with subsequent tightening moves to counter rising commodity prices in 1994, that led to virtually zero inflation and price stability over the past three years.
As for todayís oil problem, it wonít take much from the Fed to limit the inflationary potential because itís not much of a problem. We know this because falling precious metals, stable commodity indexes and a strong dollar are all signaling that future inflation over the next year will actually be lower than it is today. These market-based commodity indicators have a much more accurate inflation-forecasting record than the unemployment rate or the pace of economic growth.
Remember, inflation is caused by a drop in dollar purchasing power, not prosperity. A general increase in all prices, not just oil (or wages), is possible only when money supplied by the Fed is greater than the markets and the economy demand. The price of gold, the CRB index and the dollar index are the best measures of "excess money." Think of them as an advance scouting party; they are early warning indicators of monetary over-abundance and future inflation. Right now these "price rule" signals suggest that money is scarce, not loose.
So I donít have much enthusiasm for a Fed-tightening move. Itís not the 1970s. The oil hike will be temporary, and a King dollar-linked $260 gold price tells me that monetary policy is already tight. Then again, if new technologies have reduced the cost of producing oil to about $7 per barrel in West Texas, and $4 per barrel in the North Sea, even $18 oil canít last for very long. OPEC may think itís in control, but the world market will prove to be the eventual winner. Over time, selling prices will converge with production costs.
Actually, over the past three decades, one ounce of gold, on average, purchases 20 barrels of oil. So, if gold stays around $260, then oil could drop to $13 per barrel. And that would be consistent with 4Ĺ% to 5% long Treasury rates, as the underlying inflation trend edges below 1%. Capitalizing 3% to 5% expected corporate profits with a 5% discount rate would greatly expand price-earnings multiples and boost the stock market over the next year. Keep optimism alive.
As for the Fed, if they must tighten to offset higher oil -- last year they eased when oil dropped -- I wonít lose much sleep over it. Call it opportunistic disinflation. But unnecessary Fed tightening does risk a bigger near-term stock market correction. It will reduce growth over the next year by roughly one-half of a percentage point. Subtract another 1% from growth as business firms complete their Y2K investment upgrades. Also, incipient recoveries in Europe, Asia and Latin America may be injured. For the Y2K presidential race, Al Goreís polls will suffer.
Hereís a better idea for Greenspan and Co. Take a short ride over to the Justice Department, where all those former Jimmy Carter anti-trust busters are working their keysters off to prosecute pro-consumer Microsoft and Intel, which are producing more technology goods at lower prices, but have not uttered one peep about OPEC, whose anti-consumer and anti-growth policies are conspiring to produce less oil at higher prices.
We know that at least one American oil company, Chevron, is colluding with OPEC. So
thereís a legal hook to hang on. The Fed might suggest regulatory action against a real
monopolist, namely OPEC. And that would hasten the decline of oil prices. Sure beats
a monetary dose of castor
JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.