With crude oil rising above $75 a barrel last week and the Federal Reserve having lifted the federal funds rate 3.75 percentage points during the last two years, many economists and analysts believe that the fate of the U.S. economic expansion has been sealed. The limp-economy/weak-consumer crowd argues that an impending growth slowdown after the first quarter — the result of fifteen Fed rate hikes and ever-increasing energy prices — will act as a break on spending.
In other words, theoretically, high energy prices reduce the amount of spending on the part of consumers, which restrains demand and places a lid on inflationary pressures. This is what economists mean when they say “high oil prices are tightening for the Fed.” This theory sounds logical, but it’s as wrong as rain.
According to data from the Energy Intelligence Group, crude supplies have been expanding at an average annual pace above 3 percent since 2003, double the average growth rate going back to 1991. However, excess global central bank liquidity, a rapidly expanding global economy (industrial demand), and elevated levels of geopolitical risk (crisis demand) have absorbed all of the new supply and then some.
The end result is that the sum of industrial and crisis demands have outstripped increases in new supply, pushing prices higher. But a shift in demand at every price is consistent with more output, not less. This also is why crude oil prices actually have borne a positive relationship with economic growth during the last five years. The situation is quite different from the stagflationary 1970s and early 1980s when supply shocks reduced the amount of crude available, a contraction of output at every price.
Another myth advanced by the high-oil-is-synonymous-with-less-consumption crowd is that elevated energy prices have “crowded out” other spending. This would be true if the Fed were running a tight liquidity policy. But the Fed is not, which means households have spent more on energy products without cutting back on other goods and services. We know this because retail sales less autos and gasoline are up by a blistering 8.7 percent annual pace during the last 12 months, well above historical growth rates of 5.5 percent. In other words, with excess liquidity in the system, aggregate demand exceeds aggregate supply and prices rise. That’s inflation.
That crude oil prices reached a new nominal high last week along with the Dow Jones Transportation index holding close to all-time highs simply buttresses the point that high oil is a liquidity (demand side) phenomenon, not a slow-growth supply-shock situation. And although $70-plus crude oil sounds expensive, consider the fact that adjusted for 2006 nominal personal income, crude oil prices would have to rise to $186 a barrel to match the 1980 peak. By this measure, today’s prices remain inside one standard of the mean going back to 1959.
So when will crude oil prices fall? One of three things needs to occur before we see substantially lower energy prices. First, the global economy would need to slow, but it’s been accelerating. Second, geopolitical risks would need to soften, but they’ve been hardening. Third, the global central banks of the world — the Fed, the Bank of Japan, and the European Central Bank — would have to tighten liquidity substantially, but all three remain in an excess-liquidity posture.
So we may be stuck with high prices for a while. But it would be a mistake to expect a demand-driven rise in energy prices to slow growth or lower inflation. With commodity prices reaching record levels, credit spreads narrowing to all-time lows, and growth-and-liquidity sensitive segments of the equity market such as transports and small-caps reaching all-time highs recently, strong growth and elevated inflation readings are more likely than the converse.
— Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.