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Oil shocks trigger recessions not so much because prices have gone up sharply and suddenly, but because of how central banks respond.
In other words, by trying to stifle perceived inflationary threats from price increases, central banks overreact by tightening monetary policy too much.
This might merely be an interesting theory were it not presented in a 1997 paper co-written by one Ben Bernanke, “Systematic Monetary Policy and the Effects of Oil Price Shocks.”
As it stands, Mr. Bernanke is the chairman of the Federal Reserve, the world’s most powerful central bank. And the price of oil, not to mention other commodities, has rocketed since last summer. Which suggests the last thing the Fed is likely to do is to tighten policy as inflation gets pushed up by fast rising food and energy prices.
Most central bankers agree that inflationary wage-price spirals can be triggered by supply shocks if an economy is operating at near full capacity or close to full capacity and labor agreements are inflation-indexed, as happened in the 1970s. Indeed, something similar is happening in China and India, where large wage settlements are being reported in response to commodity price rises, while the European Central Bank fears the same for Germany.
But in the U.S. and Britain, the problem"”as U.S. and British central bankers see it"”isn’t so much that commodity prices will feed through into more generalized inflation, but that they will cause further declines in domestic consumption. That’s because food and energy prices are acting like a tax on workers who have no power to negotiate significant wage rises because of high rates of unemployment.
So far, the story seems reasonably solid.
But what if past central bank policy, namely zero interest rates and quantitative easing, are major drivers of commodity price inflation?
Mr. Bernanke denies this is the case. He argues commodity prices are responding to rising demand from developing markets, whose economies are booming.
That argument is disingenuous. Commodity prices surged with the initial Federal Reserve rate cuts in 2008 and then again following Mr. Bernanke’s heavy hints that he would launch a second round of quantitative easing last summer. Low or negative real interest rates reduce the opportunity cost of holding non-income generating real assets, like commodities and precious metals.
By Mr. Bernanke’s own admission, the Fed is using unconventional monetary policy to force investors into taking more risk and thereby into kick-starting the economy. It’s hard to see how he can claim QE is behind the rally in equity prices but not in commodity prices.
Which takes us back to Mr. Bernanke’s 1997 paper.
If QE is a major factor in causing commodity prices to rise rather than just the state of the global economy, commodity prices are likely to have moved away from what economic fundamentals justify. In which case, they will, in fact, cause a significant slowdown in growth. In other words, the Fed’s initial policy action will have caused exactly the thing the Fed wants to prevent: volatility of output.
Undoubtedly, if this happens, the Fed will respond with yet another round of quantitative easing.
Rinse, wash, repeat…
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The Fed needs to gradually start raising rates. Near zero rates are pretty much worthless for the average consumer. Consumers have little reason to save their money via banks because they are not even breaking- even when you consider annual inflation. .. all in the name of bank lending (spend-spend-spend). It is ridiculous.
Every time the US Dollar falls, commodity prices rise. Let us also not forget that some foreign nations subsidize increased commodity prices (such as China and Mexico), so little is felt by the actual consumers. This antiquated Fed policy needs to go.
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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