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The Fed Sees Energy Price-Induced Inflation, Shuts Eyes

April 28, 2011
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The Federal Open Market Committee yesterday recognised the potential import of energy price inflation, resulting from a soaring and sustained international oil price.  The FOMC is tasked with setting monetary policy.

The latest FOMC statement reads:

The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation.

It goes on to state that it:

Expects these effects to be transitory

The FMOC does not specify what ‘these effects’ are, and why they should be transitory (it is unlikely to, given the brevity of the statements).  Are the effects:

  •  The effects of inflation on the economy or;
  • the actual transmission of the oil price increase to the inflation rate?

The FOMC is extremely careful about its choice of words, as the selection of any given word can move the market.  What does this choice of words therefore mean?  Can a real signficance be found in the words, or is the statement intended as a bland dismissal of the importance of energy and commodity price inflation?

There is no reason to believe that energy price inflation (which has a heavier weighting on inflation than other commodities on the production side) effects on production cost inflation or consumer demand dissipate in the short term.  Perhaps in the medium term resource re-allocation creates efficiencies.  On the demand side, energy and other commodity price inflation is likely to compound weak economic characteristics (see for example Hamilton, 2009), with marginal price changes having an amplified ability to negatively affect consumer spending.

Equally, there is little to support a view that a given commodity price contribution to an inflation rate will reduce in the short term.  While for energy the contribution to core inflation, value add and as a share of GDP has declined over time, only a rapid re-aligment of resources will change this picture in the short-term.

If the words are poorly chosen, and instead the FOMC means that commodity prices themselves are transitory, then they provide no justification for this view, and many would disagree with this prognosis.  This is particularly true if one ascribes to a typical simplified perception of an inverse correlation between US economic output and imported oil price (more on this relationship in the future). 

The fact that the FOMC statement is on the light side of bullish as far as the general outlook for the US economy is concerned; that significant demand-side risks elsewhere in the world do not look substantial enough to rapidly and significantly erode commodity prices; and that supply-side constraints and risks persist, would suggest that a sustained outlook for high-ish commodity prices will not disappear in a hurry.  If they think there might be an immediate price decline, then it will be informative to understand why.

In short, energy price-induced inflation is here.  The strategy so far is wait-and-see.  The obvious monetary response tool is to increase interest rates.  Then the question becomes – if one ascribes to the view that commodity price increases are based on fundamentals – whether it is desireable to marginally curb US demand, and whether it would actually signficantly influence commodity price inflation given the partial exogeneity of these inputs due to price-setting import of factors external to the US economy.

A greater focus on structural changes to address energy security is needed.

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