Thursday, March 22, 2007

Understanding Inflationary Pressures - Oil

Ah at last the market has direction...right? Like clock work the markets sprang to life immediately after the Federal Reserve announced its intention to hold interest rates at 5.25%. The Fed concluded its two year, 17 quarter-point consecutive rate hike in June of 2006. Since then we have seen inflation drop from a high of 4.32% to a low last year of 1.31%. Recently, inflation has creep back as last weeks economic data reported that price pressure still remain a problem. "Excluding food and energy, consumer prices have been rising this year at an annual rate of 3 percent, far above the Fed's 1 percent to 2 percent comfort zone."

Despite a weakening housing market and Greenspan's economic recession threat last month. The Fed reiterated it was more worried about inflationary pressures than weak economic growth. They however, neglected to comment on the likelihood of future rate hikes. "In its place, the Fed said that any 'future policy adjustments' would depend on the performance of both economic growth and inflation."

Interest Rates

The manipulation of interest rates are specific monetary policies which lag economic activities. Meaning actions today will take time before full maturation. For example, during 2005 and most of 2006 we witnessed simultaneous rate hikes coupled with inflation. It wasn't until the end of 2006 inflationary pressures dropped drastically. Interestingly, the significant drop in inflation during mid June timed perfectly with the Fed's final rate cut. Could it be that the Fed miraculously timed the final rate cut to coincide with inflations dramatic drop? Why then with rates effectively unchanged from June 2006 to now, has inflation only recently start to trend higher? Could it be that the economy was growing at too rapid of a clip, thus causing demand-pull inflation or are we witnessing the occurrence of multiple catalysits.

Cost Push Inflation and Energy

Cost Push, demand-pull, its all inflation so who cares? This is true, however they each have very different implications. Without going into excessive detail, I will try to convey the basics between these two as well as highlight their individual significances.

Demand-pull inflation or the inflation the Fed is attempting to control originates from increasing aggregate demand, or the sum of all the demand on the economy. General causes for an increase in demand stem from factors including: increase in government spending, increased access to money suppy(rate cuts) or increases in global prices.

Simply put, as the economy grows, increases in consumption lead to decreases in inventories, which leads to increases in production, decreases in unemployment, increases in income and in turn additional increases in consumption. This results in economic growth and if left unchecked will result in inflation as the aggregate demand for goods and services out strips aggregates supply. This type of inflation can be corrected by decreasing the money supply such as the Fed has done during the past two years.

On the other hand Cost-Push Inflation, or supply shock inflation, results from a reduction in aggregate supply. This reduction in supply can result from an increase in wages or an increase in the price of raw materials when no viable alternative is available.

In resent history we witnessed this during the 1970s petroleum shock. Due to oil's inseparable connection to economic growth, any supply constraints will inflate the cost of everything from the food we eat to the computers we buy. As the prices of these goods and services rise with the cost of energy so do inflationary pressures. Attempts to control this type of inflation through the use of rate cuts will only be successful once economic growth is stifled(recession) and the demand for the supply diminished. Only then will prices correct and inflationary pressures be eased.

In 1996, a barrel of oil was selling for around $10. A decade later, oil hovers near $60/barrel for an impressive 500 percent increase. Observing the chart posted in the link below; I plotted the approximate price of crude using the United States Oil Fund (USO), an Amex listed ETF which roughly mirrors the price of oil. Observe how oil makes consecutive highs throughout 2004, 2005 and the first half of 2006. During the exact same period inflation and rate hikes crept higher. Then in August of 2006 the price of oil collapsed and and with it so did inflation. Now with oil on rise again we are witnessing a similar pattern. The question is where do we go from here? Will oil continue higher as the summer driving season approaches? Will the Fed continue raising rates in an attempt to curb inflation? And more importantly, what will amount to Greenspan's talk of a recession.

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