The Job Market, Oil Prices, and the Fed
By Scott J. Brown
March 4, 2011
Higher oil prices have raised new concerns about the strength of the economic recovery. If sustained, the rise in gasoline prices will restrain the pace of economic growth noticeably, but does not appear to be large enough (so far) to derail the expansion. Meanwhile, a federal government shutdown looms as lawmakers bicker over the future path of expenditures. Austerity at all levels of government is well-intentioned, but is not advisable at this point in the economic recovery.
Higher oil prices are often associated with recessions. In fact, $4 gasoline was a contributing factor to the Great Recession. The economic impact of higher oil prices depends on the magnitude of the increase and also the duration. Brief spikes generally do not have a big effect on growth.
As a rule of thumb, a $10 increase in the price of oil corresponds to about a 20 cent increase in the price of gasoline or about a 0.2 percentage point reduction in real GDP growth. However, that estimate does not account for multiplier effects. A large, sustained increase in gasoline prices, will reduce spending on other thing, leading to broader jobs losses (or smaller job gains) than would have occurred otherwise. If sustained, the recent rise in oil prices could shave about 0.5 to 1.0 percentage point from GDP growth – not enough to cause a recession, but not helpful to the recovery. If GDP growth was expected to be 3.5% to 4.0% this year, we may see 2.5% to 3.5% instead. Note also that higher gasoline prices have a mixed effect across income. The top 20% of income earners account for about half of income growth and about half of consumer spending. Those households don’t care much about what it costs to fill their SUVs. For those at the lower end of the income scale, higher gasoline prices matter a lot more.
The recession contributed to a sharp drop in tax revenues at all levels of government. Revenues have rebounded as the economy expands, but are not back to where they were. Most states and local governments have balanced budget requirements. Remember, a third of the federal fiscal stimulus was aid to the states. About 70% of that went to education and healthcare, with no requirements that these governments work to reduce future budget deficits. That federal support is winding down, but the budget strains remain. As a result, many states are cutting government jobs. State and local government shed about 20,000 jobs per month in 2010. Normally, they would be adding about 20,000 per month – more or less in line with population growth. While we all would like to see leaner, more efficient governments, in the short-term these job losses weaken the economic recovery. These workers have families and mortgages and spend most of what they make.
We are now five months into FY11. Of the 13 appropriations bills that fund the government, lawmakers have passed not a single one. The fifth Continuing Resolution will expire on Friday (March 4) and a government shutdown looms if an agreement cannot be reached. Most likely, we’ll get a sixth Continuing Resolution to cover government operations for a few more weeks. Many Republican lawmakers, those who have been around for a while, remember the lesson of the last government shutdown (1995), which elevated Bill Clinton’s standing with the public and damaged the Republicans. However, the newer breed of Republicans, swept in on the Tea Party sentiment, do not remember, or choose to ignore, this particular history. The 1995 showdown was the result of differences between a Democratic president and a Republican Congress. This time, the split is entirely in Congress – and even within the Republican party. The leadership would likely negotiate, but can’t get the troops to compromise. Within the next few months, Congress will also have to approve an increase in the federal debt ceiling. The U.S. government is not going to default on its debt, but the threat may unsettle the markets to some extent.
The Monetary Policy Outlook
February 21 – 25, 2011
Fed Chairman Bernanke is set to deliver his monetary policy testimony next week. There’s not much suspense. The release of the FOMC minutes from the January 25-26 policy meeting included senior Fed officials’ revised projections of growth, unemployment, and inflation, as well as a thorough discussion of the uncertainties. No change in monetary policy is expected for some time. However, the Fed will have to consider when to lose the “extended period”language and eventually move to a more normal policy position. That doesn’t look likely for 2011.
At the January 25-26 FOMC meeting, in preparation for the semi-annual Monetary Policy Report to Congress, senior Fed officials submitted revised forecasts for the next couple of years. The central tendency forecast of GDP (which excludes the three highest and three lowest of the forecasts of the six Fed governors and 12 district bank presidents) was raised to 3.4% to 3.9% (4Q11-over-4Q10), vs. a range of 3.0% to 3.6% seen in November. Despite the improved growth outlook, the unemployment rate was expected to edge down grudgingly in 2011 (8.8% to 9.0% in 4Q11), with a larger decline beyond that.
There was a wide range of uncertainty in inflation projections, but most Fed officials expected core inflation to trend in the lower part of the comfort range (1% to 2%). According to the FOMC minutes, “many participants expected that, with significant slack in resource markets and longer-term inflation expectations stable, measures of core inflation would remain close to current levels in coming quarters.” However, “the importance of resource slack was debated, and some participants suggested that other variables, such as current and expected rates of economic growth, could be useful indicators of inflation pressure.” Following the disinflationary trend in 2010, some increase in inflation is welcome. However, despite worries about higher commodity prices, consumer price inflation is not expected to get out of hand anytime soon.
Prior to the mid-year slowdown, Fed officials spent the first half of 2010 testing the exits. The Fed has a number of tools (such as reverse repos and time deposits for depository institutions) to remove reserves from the banking system when appropriate. However, a sharp tightening in monetary policy is unlikely. The Fed will eventually have to take the foot off the gas pedal (not necessarily “hitting the brakes”) as a “normalization” of monetary policy. Removing the conditional commitment to keep short-term interest rates near zero for “an extended period” will depend on a change in the Fed’s stated conditions: low rates of resource utilization (equivalently, an elevated unemployment rate); a low underlying trend in inflation; and well-anchored inflation expectations.
The Fed has been criticized for its asset purchase program (“quantitative easing”), partly by those who don’t understand that the Fed’s asset purchase program is merely a way to ease policy when up against the zero interest rate bound, and partly by those who fear that easy monetary policy will fuel inflation more generally. The Fed’s asset purchase program will end on schedule, but there’s no need to raise rates anytime soon.
Inflation Anxiety – Misplaced?
February 14 – 18, 2011
Commodity prices have moved sharply higher over the last several months, leading to increased worries that the Fed is “behind the curve,” “debasing the currency,” or “monetizing the debt.” Such fears are based on a poor understanding of the inflation process and how the Fed conducts monetary policy.
No doubt, prices of raw materials have risen. There are some basic reasons for this. One is the global growth story. Increased demand from China, India, and others will put upward pressure on commodity prices. Commodity prices are also a function of interest rates. Low interest rates cause a relative increase in the value of stuff in the ground (due to lower discounting), creating less incentive for extraction, and reducing the cost of holding inventories. Perhaps more importantly, there is a speculative element, which was plainly evident in 2007 (and that speculative element is also a function of low interest rates).
A drought in Russia has put upward pressure on grain prices. The demand for food is relatively inelastic (that is, price changes generally don’t have a big impact on the quantity demanded). Hence, it doesn’t take much of a change in supply to have a big impact on food prices. China is also experiencing a drought, which is likely to keep wheat prices elevated. However, high prices tend to encourage higher crop yields down the line.
Many are old enough to remember the Great Inflation of the 1970s and early 1980s. Having lived through that, it’s natural to be concerned that we may be about to repeat that experience. However, the backdrop is a lot different now. In the early 1970s, one out of four private sector workers were in a union. Many of those unions had cost-of-living adjustments (COLA) in their wage contracts. So, an oil price shock lifted the CPI, union wages rose, followed by non-union wage increases, and inflation quickly became embedded in the labor market. It took an induced recession by the Volcker Fed to wring inflation expectations back down. In contrast, union membership in the private sector was less than 7% in 2011 (a greater percentage of government workers are union, but they don’t have much bargaining power on wages). We’ve had a number of oil price increases over the last 10 years and none has lead to higher wage demands or an increase in the underlying inflation trend. Instead, higher energy prices tend to dampen growth.
Consumer price inflation is driven by inflation expectations, which remain well-anchored, and by the amount of slack in the economy. While the economic outlook has improved, the unemployment rate is expected to remain elevated for a number of years. Capacity utilization is rising, but remains relatively low by historical standards. Slack in production implies that we’re likely to see few bottleneck inflation pressures in the foreseeable future. For manufacturers, commodity price inflation is real. However, firms still generally have a relatively limited ability to pass higher costs along.
What role does the dollar play in higher commodity prices? Not much. Commodity prices are higher in all currencies, not just the dollar, and the dollar isn’t all that weak against the major currencies. Also, it does not matter that oil and other commodities are denominated in dollars.
What role has U.S. monetary policy played in commodity prices? Some, but not as much as you might think. In general, easier monetary policy implies higher commodity prices (see the interest rate explanation cited earlier). More importantly, think about how the Fed conducts monetary policy. Raising or lowering interest rates is meant to influence the rate of loan growth, helping to ease or tighten pressures on resources (capital and labor). Does anybody think that private-sector loan growth is currently excessive? That doesn’t appear to be the case in the U.S., but could be an issue more globally. However, that’s an issue for foreign central banks. Commodity price pressures are largely a transitory problem (food, especially), partly fueled by speculation. This isn’t the 1970s.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
(c) Raymond James
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