Oil & the Dollar, Factors on the Minds of Fed Offi
Washington, DC, November 1--Oil prices and the dollar are emerging as key factors for Federal Reserve officials ahead of next week's expected rate increase and the subsequent debate over whether to raise rates again in December.
Fed officials believe that the increase in oil prices since spring has dampened what would otherwise have been a brisk expansion and that higher oil prices haven't raised inflation noticeably. That boosts the odds that the Fed will take a breather after it raises its key interest rate by one quarter percentage point to 2% on Nov. 10, as is widely expected. Starting in June, the Fed has lifted its target for the federal-funds rate -- the rate at which banks lend to each other -- three times in quarter-point increments.
Further declines in the dollar, however, could encourage Fed officials to continue raising rates. They believe the dollar's relative strength, despite its recent dip, has slowed growth by fueling a record trade deficit, because a stronger dollar makes imports to the U.S. relatively cheaper and U.S. exports more expensive. That crimps American export manufacturers, limiting their role in the domestic economy. A weaker dollar could turn U.S. consumers more toward local goods, fueling domestic production and employment and boosting import prices -- all of which might argue for higher interest rates.
Fed officials cite high energy prices as the main risk to the economic outlook. "The recent run-up in energy prices poses some challenges," Fed Vice Chairman Roger Ferguson said Friday in a speech. Fed Gov. Ben Bernanke said earlier, "The recent rise in oil prices has...been large enough to constitute a significant shock to the economic system," subtracting one-half to three-quarters of a percentage point from growth so far this year.
If oil prices retreat soon or if the pace of business hiring and investment spending picks up, the chances of another rate increase in December rise. Futures markets on Friday were predicting a less than 50% chance of a December rate increase.
Higher oil prices present a dilemma for the Fed because they crimp growth, which usually calls for lower interest rates, while boosting inflation, which calls for higher interest rates. But since June, long-term bond yields have tumbled, suggesting that markets don't expect a sustained upturn in inflation. Bond yields are sensitive to inflation, which erodes the value of the bondholder's return.
Fed officials cite several reasons not to fret too much over oil. Adjusted for inflation, the rise in imported oil costs is far smaller than what the U.S. experienced in the 1970s. In addition, overall prices have risen less than that of the much-sought benchmark West Texas Intermediate grade. And Fed Chairman Alan Greenspan said the recent stability of long-term futures prices suggests the latest jump in spot prices is temporary.
If Fed officials do raise rates next week, they will probably give little hint in their end-of-meeting statement as to what they will do next. They say their oft-repeated plan to raise rates at a "measured" pace could mean continuing to raise rates at each meeting, or pausing for a few meetings to gauge the economy's strength.
Still, the Fed's uncertainty about a December rate move represents a shift in its thinking. In raising the funds rate from 1% to 1.75%, the Fed was driven less by the ebb and flow of economic data than by a desire to raise the rate from an "emergency" level appropriate only when deflation was the main worry.
In recent weeks, Fed officials have emphasized the importance of incoming economic data in their deliberations, and de-emphasized the urgency of returning rates to "neutral." Neutral, in Fed jargon, means a level that neither stimulates nor restrains growth, and is commonly estimated at 3% to 5% in the long run.
