Interest Rate Roundup

Wednesday, May 21, 2008

Thoughts on oil prices, demand destruction, and the role of the Fed

Demand destruction is the fancy economic term for what happens when the price of a commodity (in today's case, oil) gets too high. Once the price goes up so much, users can no longer afford the cost. They find ways to conserve and cut back on oil usage. This destroys demand for the commodity, and prices collapse.

I got to thinking about this topic after reading the following New York Times story on American Airlines. Is this a sign that high prices are starting to destroy demand (by driving fares out of reach of U.S. consumers, by forcing airlines to cut capacity -- thereby reducing demand for jet fuel, and so on)?

"American Airlines, the nation’s largest air carrier, said Wednesday that it would begin charging $15 for many passengers to check their first bag, eliminating a free service that passengers in the United States have come to expect during the modern jet era.

"American made its announcement during the annual meeting held by its parent company, the AMR Corporation, in Fort Worth.

"At the same time, American said it would take up to 85 aircraft out of its fleet, including jets and commuter planes, by the end of the year, one of the biggest cutbacks since the airlines culled their fleets after the September 2001 attacks. American has about 960 aircraft at the mainline airline and its American Eagle subsidiary.

"The reductions will translate to an 11 to 12 percent cut in service during the fourth quarter, American officials said. They said the airline would eliminate some jobs, but did not give specifics."

Speaking of oil prices, here is what Bloomberg had to say about the latest surge in oil prices (crude was recently up more than $3.20 a barrel to $132 and change) ...

"Crude oil rose to a record above $132 a barrel as U.S. stockpiles unexpectedly dropped and banks raised price forecasts because of supply constraints and demand growth.

"Supplies fell 5.32 million barrels to 320.4 million last week, the biggest drop in four months, the Energy Department said. Oil for December 2016 delivery rose more than $19 a barrel, or 16 percent, after Goldman Sachs Group Inc. on May 16 raised its outlook to $141 a barrel for the second-half of the year.

"What we have here is a situation where essentially higher prices aren't generating any more supply," Paul Sankey, an analyst at Deutsche Bank Securities in New York said in an interview with Bloomberg radio. "What we have to do is keep pricing the commodity higher until demand starts falling,'' which "is around $150 a barrel.''

"Crude oil for July delivery rose $2.53, or 2 percent, to $131.51 a barrel at 12:27 p.m. on the New York Mercantile Exchange, after reaching $132.08. Prices have almost doubled from a year ago."

My personal take, for what it's worth, is that a fundamentally strong market is now morphing into just the latest in a series of speculative bubbles. Lots of forces have been driving oil prices higher for the past few years. But we are now making the boom-to-bubble transition thanks, in part, to our friends at the Federal Reserve.

They threw easy money at the dot-com bust, creating the monetary conditions necessary for a housing bubble. In the past several months, they have been throwing easy money and rate cuts at the housing bust. That has now poured monetary gasoline onto an already red-hot fire in oil and other commodities. In other words, the Fed is accomodating the rise in commodities prices -- just like it did in the 1970s -- and the result is the miserable version of Stagflation-lite we have today.

Vice Chairman Kohn tried to play down this version of events yesterday, saying the following:

"Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one."

But I don't agree. You simply can't run a persistently negative interest rate policy without consequences. You simply can't keep bailing out the last round of speculators without emboldening the next round. Yet here we sit, with a 2% nominal funds rate and a 3.9% year-over-year rate of CPI inflation, and the Fed doggedly pursuing its "Trash for Treasuries" policy.

Anyway, some more thoughts on the oil bubble/no bubble argument can be found at the Econbrowser blog and RGE Monitor, if you're interested.

2 Comments:

  • I'm new to the blog, so wanted to say hello. I've enjoyed reading the little that I have.

    I see CNBC has an article with someone predicting $12 gas and rationing in the near future! Sounds a bit doom and gloom to me. http://www.cnbc.com/id/24725305

    By Anonymous Primrose, at May 21, 2008 at 9:11 PM  

  • If the numbers were calculated the same way as in the 70's it wouldn't look much like Stagflation-lite. Since I view the current period as roughly equivalent to 1969 it makes me shudder to think where we might be after 10 more years of the free money prescription for everything that ails us.

    By Anonymous Anonymous, at May 24, 2008 at 2:29 PM  

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