Hundred dollar oil, five percent inflation, and the coming recession: why the fed is in trouble.

• Author: Verleger, Philip K., Jr.
• Position: Economy

Many believe the continuation of current low inflation depends solely on the Federal Reserve s ongoing ability to maintain a stable price environment. Proponents of this "monetarist" view belittle warnings that rising prices in one sector or another threaten to boost inflation rates. Echoing Milton Friedman's famous dictum, they assert that price levels are determined strictly by monetary policy.

The collapse of labor's market power brought about by free trade, deregulation, and more competitive retailing has clearly strengthened the ability of the Federal Reserve and other central banks to limit the pass-through from shocks into wage and price pressures. Their power to contain prices, however, is still not absolute. Constraints remain. Today, one of those limitations can be found in the energy sector where an industry already operating at essentially full capacity has just suffered major, nontransitory capacity losses. Additional capacity reductions can be expected in the next year. Repair of existing capacity, not to mention expansion, will take several years. (1)

In 2006, inflation rates may rise to above 5 percent in the United States if economic growth continues at current rates, even if the dollar holds its value. Such an increase in inflation would be caused by economic growth that would pull oil prices to $100 per barrel. It is unlikely that the Bernanke-chaired Federal Reserve Board can or will tolerate such increases in inflation. Interest rates will rise. Output growth will slow and the United States could fall into recession. This recession, like the previous three instances, will be caused by constraints in the energy sector.

THE BACKGROUND OF RISING OIL PRICES AND PAST RECESSIONS

Oil prices surged from $10 per barrel at the beginning of 1999 to almost $70 in September 2005, a rate of almost 40 percent per annum. The rise in prices can be associated with three specific periods in the global oil market (see Figure 1). The first period occurred from roughly 1995 to March 1999. During this time, markets were characterized by surplus capacities in all areas. OPEC members produced at far below capacity. Natural gas supplies in the United States and Europe exceeded demand. Petroleum refineries operated at less than capacity.

[FIGURE 1 OMITTED]

The second period began on March 1, 1999. On that date, Saudi Arabia coerced production cuts from other OPEC members and from Russia, Mexico, and Norway. At the time, crude oil traded for $10 per barrel. Saudi Arabia announced it would boost production by almost 50 percent, thereby collapsing oil prices further if other producers did not agree to reduce output. Saudi leaders also explained to oil producers that every country would gain if they lowered production. Everyone cooperated. From March 1999 to the spring of 2004, oil-exporting countries aggressively sought to restrain production and keep inventories in consuming countries low. The strategy led to crude price increases followed by product price increases. It was an artificial (not a fundamental) supply constraint, but it worked just as well as a real one.

From the spring of 2004 on, the world has confronted a genuine constraint, one not related to crude oil but to refining capacity. In the United States, natural gas supplies have been squeezed as well. Product prices have surged and crude has followed. The refining constraint has occurred because world refiners have been unable to meet consumer demand for products meeting specifications established by environmental regulators in the major oil-consuming economies. Rapid, partially unexpected increases in demand for products in China, India, Europe, and the United States have required substantial product price rises. Arbitrage has caused crude to follow.

The rise in energy prices creates a new problem for economic policymakers because the capacity constraints cannot be easily addressed over the next four years. Increased demands for products must be met by sharply higher prices to balance consumption with capacity. Central bankers must fight a new war that is more challenging than constraining inflation expectations has been of late, given weaker pricing power and labor bargaining strength. Over the last several years, the central bank has remained extraordinarily relaxed as unemployment rates have dropped. Former Fed Chairman Alan Greenspan has repeatedly mentioned the effect of globalization and deregulation. In February 2004 testimony, he remarked, "A consequence of the rapid gains in productivity and slack in our labor and product markets has been sustained downward pressure on inflation." (2) Seven years earlier, Greenspan had heralded the Phillips curve's flattening when he commented on the "atypical restraint on compensation" that had been evident for an extended period. (3)

THE NEW WAR: THE VERTICAL SUPPLY CURVE FOR ENERGY

Labor is not and never has been the sole contributor to inflation. Weaker foreign exchange rates or rising prices for key commodity prices can and have contributed to the problem. Today central banks face a new constraint on their action from a vertical (totally inelastic) supply curve for energy. For reasons discussed below, the constraint from the energy sector will be one of the most important factors--if not the most important--facing monetary policy officials for the next three to four years if the global economy continues to expand. The energy constraint must dominate policymaking because it will almost certainly limit the growth of potential GDP for the next five years. Indeed, the energy constraint could propel the U.S. economy into a deflationary cycle if it is improperly addressed.

Unfortunately, the energy constraint, to this date, has been misunderstood at the Federal Reserve, if speeches by Greenspan in the last year of his chairmanship are representative. In addresses in Tokyo and New York in 2005, he spoke of the long-term trends in the development of oil and gas reserves; technological innovation, especially regarding the growth of liquefied natural gas; the U.S. economy's improved energy efficiency; and the market's role in encouraging conservation. (4) While these historical reviews make interesting bedtime reading, they totally overlook the central problems in today's energy market, to wit,

* The energy industry in the United States and much of the world today lacks the capacity to transform...