The recent spike in oil has caused a surge in media coverage, dredging up everything from comparisons to the oil shocks of the 1970s to the implications on global growth and stability. What I see is a clear example of the predicament the Fed finds itself in as it tries to reinflate the economy.
The central bank’s monetary-policy moves—first the cutting of short-term rates to zero and now the buying of longer-dated Treasury debt—are meant to cheapen credit costs in the hopes of reflating wealth-creating assets, stocks and real estate in particular. Real estate is still dropping these days, but stocks have cooperated thus far, rallying about 25 percent since September.
But, as Pimco’s co-Chief Investment Officer Mohamed El-Erian has been pointing out, because the Fed only has these “blunt” instruments at its disposal, it inflates wealth-destroying assets as well, namely food and energy. I think we’re reaching an inflection point when the inflation of wealth-destroying assets outweighs the benefits of the increase in assets like stocks.
The true economic impact of high oil prices is a big topic of debate among economists. The consensus seems to be that a $10 rise in the price crude takes away 0.5 percent from economic growth in the year or two following that increase. Oil shocks, however, can have a much more potent effect, as the St. Louis Fed discussed in a paper in April 2008.
The Fed paper argues that capital spending by businesses can slow down not only because of the direct impact of rising oil prices, but also due to uncertainty surrounding the trajectory of prices.
In addition, capital and investment will often be reallocated away from the affected sectors to the “less affected sectors,” which can also be costly. These two variables add downward pressure to real GDP growth. In other words, people’s reaction to the prospect of rising oil prices can amplify the effects of high energy prices.
The paper came out a few months before oil spiked to its previous high of $147 per barrel in the summer of 2008. It’s no stretch to assume that those high oil prices contributed to the stock market crash and rapid slowdown we saw going into 2009. Since oil prices are only 40 percent off their highs at this point, it’s worth comparing today’s economic conditions to those in 2008.
Fortunately, the U.S. economy is currently gaining momentum, and continues to surprise to the upside. New orders from the latest Chicago PMI number hit their highest level since 1983, and the Institute for Supply Management’s data on both factories and services are strong.
However, in my mind, a key question remains: What is the price we are paying for this growth?
Overall, it seems to me U.S. consumers are in worse shape heading into the current oil price spike than they were in 2008.
For example, unemployment in the U.S. was roughly 5 percent at the start of 2008 versus the 9 percent currently.
Over 6 million of the 14 million unemployed have been out of work for more than six months. Personal income minus transfer payments, such as unemployment benefits and food stamps—better signs of the true vitality of the consumer—is roughly $400 billion below where it was at the start of 2008.
Also, total U.S. household net worth at the end of the 2010 third quarter is roughly $10 trillion, or 15 percent, below where it was going into the market meltdown.
Another important aspect of the 2008 economic context, that is relatively less dangerous today, is the health of the banking system. In summer of 2008, the financial system was already scrambling for both liquidity and capital—although quietly—as it took measure of losses from mortgage-related assets and general consumer debt continuing to mount.
The uncertainty of the fates of Fannie Mae and Freddie Mac, questions about the durability of the investment bank business model, and a general slowing of economic momentum also played major roles.
While the collective magnitude of the threats are arguably less today than they were then, the head winds for the banking system in Europe could be enough on its own to destabilize the global financial system. Portuguese bond yields hit all-time highs this week, as have as Greek sovereign CDS spreads as the market continues to demand some type of restructuring.