How Will US Fed React To Low Oil Prices

Falling oil prices are the newest wrench in the Fed’s decision making, but the effect might seem counter-intuitive.

Since the Fed’s last meeting in October, oil prices have fallen 25%. With a meeting scheduled for this week, markets have two major questions about the Federal Open Market Committee’s (FOMC) decision: how long will rates stay at zero, and will oil prices change that? There is a growing belief among market participants that the FOMC’s first rate hike will be delayed by the glut of oil.

That sentiment is misplaced. If anything, the fall in oil prices will cause the Fed to raise rates earlier. Inexpensive oil has had a stimulative effect on the US economy and will have no effect on the more relevant measure of inflation: core inflation.

Two kinds of inflation

The Federal Reserve prints two different inflation numbers: personal consumption expenditures (PCE) inflation and core PCE inflation. Both are calculated in the same way, but core PCE inflation excludes food and fuel prices.

While it may seem like a mistake – after all, food and fuel are the second and third largest spending categories for US consumers – the point is to strip out the most volatile prices and give a clearer image of systematic inflation in the economy.

Short-term supply constraints, like droughts and oil spills, cause large swings in prices without any real changes in the economic fundamentals. Usually, the two measures move up and down together but the recent fall in oil prices will lead to a divergence.

Which kind of inflation does the Fed use?

The Fed has not hit its inflation target since April 2012, which suggests that raising interest rates is not an immediate concern. Falling oil prices will only add more downward pressure on broad measures of inflation. Still, the question is whether the Fed will pay attention.

If it does, it could justify keeping rates near zero beyond mid-2015, the consensus timing before the oil price decrease began accelerating in November.

The decision will hinge on whether the Fed puts more weight on PCE inflation or core PCE inflation. Unfortunately, the Fed’s recent statements do not differentiate between the two. Forecasts for both versions are given along with the Fed’s regular statements every six weeks. According to James Bullard, President of the St. Louis Fed, the Fed focuses on core inflation, but still puts weight on the headline figure.

Recent history supports Mr. Bullard’s view, even to the extent that the Fed will prioritize core inflation when there is a divergence between the two measures. When Ben Bernanke was in Ms. Yellen’s position in 2011 and oil prices were spiking, he made clear (well, clear for a central banker) that swings in oil prices would not change the Fed’s path. That points to basing policy on core inflation. The rationale is simple: volatile prices are noise concealing more fundamental signals in the economy, which are the Fed’s main concern.

Mr. Bernanke lobbied for this position ten years prior when he was on the Fed’s Board of Governors in what is one of the rare instances that the Fed has commented on the topic. He also wrote an influential academic paper on the subject in 1997.

While we do not have a clear indication of Ms. Yellen’s thoughts on the subject, Mr. Bernanke’s views are a good starting point. The two have mostly moved in lockstep on other major issues during the last six years, and Ms. Yellen has shown a willingness to set aside headline figures for better indicators during her time as Fed Chair.

Earlier tightening?

Lower oil prices, through lower inflation, will not have a direct impact on Fed policymaking. But that does not mean it will not have an impact. Cheaper oil frees up extra cash for consumers to spend and for businesses to expand. Even if prices stabilize at around $60, where they are now, each US household will have saved an average of $500 since last November.

The extra economic activity, catalyzed by cheap oil, will lead to faster growth: UBS estimates that for every $10/barrel oil prices fall, US GDP will increase by 0.1%. Using that estimate, the decline in prices since June would add 0.5% to 2014 GDP. Since economic growth is inflationary, the decrease in oil prices has the counter-intuitive effect of increasing inflation rates. Cheap oil chips improve both of the indicators that the Fed’s mandate targets, unemployment and inflation.

If oil prices continue to fall, like more analysts and industry insiders are predicting, the Fed will raise rates earlier than it otherwise would have – not later, as former PIMCO boss Bill Gross predicted.

By Alex Christensen

Source – www.globalriskinsights.com