The Oil Market Strikes Back

    Samuel Rines

    economy, Americas

    Oil prices moving higher is not purely a positive for the U.S. economy, but it is certainly not the negative it was in the past.

    Oil prices moving higher is not purely a positive for the U.S. economy, but it is certainly not the negative it was in the past.

    It is not an obvious connection, but the Fed and oil are inextricably intertwined. When the Fed is engaging in loose monetary policy, it tends to weaken the dollar and inflation tends to rise. A weaker dollar has a tendency to support commodity prices by making them cheaper in other currencies.

    So how did the Fed reengage in the oil-price game? By subtly shifting from a 2 percent inflation target toward a more amorphous target that allows for some overshooting of that 2 percent, the Fed is saying is will move more slowly in tightening monetary policy. Lower and slower rate hikes (or “looser” policy) is a tailwind to the commodity complex. Not only does it tend to allow the dollar to fall (at least relative to where it would have been) and inflation to pick-up more, the lack of a restrictive monetary policy should allow the growth cycle to continue for a longer than otherwise possible.

    A couple leaps of faith need to be taken to put the pieces together here. The most critical is that the Fed is serious of inflation symmetry. Another is that the natural rate (or neutral rate) of interest, which is where the Fed transitions from loose to tight monetary policy, is somewhere around 1.75 percent at the moment with a likelihood of moving up to 2.5 percent.

    Symmetry is a crucial part of the argument that follows because it sets the framework the Fed will operate within for the next several years. If the Fed is going to maneuver with a tolerance for inflation overshooting, it will need to set policy accordingly. To set policy in a manner that allows inflation pressures to build (but reduces the likelihood of a significant 1970s style flare-up), it should maintain a near-neutral stance in the interim. As of the most recent update, the real natural rate of interest is barely positive.

    The nominal natural rate (at the end of 2017) was about 1.6 percent using the Fed’s favorite inflation measure of core PCE. Following the Fed’s hike in March, the fed funds rate is sitting at about neutral with the range of 1.5 percent to 1.75 percent. With inflation pricking up a bit and the economy doing better, the neutral rate should move higher toward the cycle peak of a bit shy of 2.5 percent over the next year or so. At the end of 2018, neutral should be close to 2 percent to 2.25 percent.

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