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Dennis Lockhart, president of the Atlanta Fed, argued this week that the Federal Reserve shouldn’t rule out further quantitative easing once QE2 winds up in June – if the Middle Eastern crisis causes the U.S. economy to nosedive again.
He echoed widespread concerns that surging oil prices would put the brakes on a recovery that only just seems to be taking hold. With Brent crude hovering at around $115 a barrel, having made at stab at $120 over recent sessions, investors are looking back to the summer of 2008 when oil made a run at $150 a barrel.
In retrospect, it seems quite clear that oil spike was as relevant to the ensuing global recession as the Lehman Brother’s bankruptcy.
But what if the Fed’s easy monetary policy was behind both oil spikes?
There’s an argument that the U.S. central bank put a rocket under commodity prices with its massive infusion of liquidity during its dramatic series of rate cuts in early 2008. And then, since last summer when Ben Bernanke made it clear the Fed would be launching another round of quantitative easing.
The simple interpretation was that all this extra liquidity the Fed created had to find a home, and that home was any and every asset. A more nuanced version was that while much of the Fed’s monetary infusions didn’t actually make it into circulation–it continues to sit in huge bank reserves–by compressing interest rates to zero, the Fed made it less costly to hold speculative assets.
Investors’ fears of rising inflation fed speculative demand for real assets, which they bought and put into storage.
It’s not just oil prices that have soared. So too have industrial metals, agricultural commodities, precious metals and everything else that can be stored.
Ultimately, this speculative demand will need to be reinforced by underlying consumption demand, and this will only happen if wages track the rise in commodity prices. In other words, consumption will follow oil prices if inflation really does take off.
But if earnings don’t tack commodity prices, household spending on other goods will be squeezed. This will have the effect of reducing aggregate demand and slowing down the economy.
In the first instance, central banks are likely to raise interest rates, which would cause commodity prices to fall. In the second, recession would equally cause commodity prices to plummet, as it did in the second half of 2008 and start of 2009.
This self correcting mechanism can take a while to kick in. And with ugly consequences.
But what if the Fed were to withdraw some liquidity from the system. This seems counterintuitive and contrary to Lockhart’s proposal. But if Fed-driven speculation is causing commodity prices to soar, then the Fed might do well to puncture this speculative boom.
In other words, the Fed could hike rates to get the economy going.
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The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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