Thursday, February 16, 2012

Rising Oil Prices: Has the Fed Been Too Clever By Half?

In eviscerating interest rates and quantitatively tranquillizing (we're way past easing), the Fed has sought to push investors into risk assets. Investors have responded. Stocks have risen sharply over the past six months. More disturbingly, oil and gasoline prices have bounced up, too.

The standard explanation for rising oil prices--demand from emerging markets like China and India--seems less plausible now that these economies are slowing down. The threat of Iran going off the deep end points toward higher prices. But Saudi Arabia's expressed intention to keep prices stable can't be taken lightly either.

However, the flood of liquidity that has come out of the Fed surely is a factor in rising petroleum prices, as all this cash has to find a home somewhere in the financial system. Rising oil prices create jobs in some parts of the country, but discourage consumers in all parts. While oil consumption won't fall much in the short term (because demand for gasoline is relatively inelastic, as economists would put it), consumption of clothes, food, vacations, and other things will suffer as gas bills snarf up the monthly budget. Recently improving economic statistics may reverse their trend.

The distribution of income enters the picture. Owners and sellers of risk assets benefit handsomely from the Fed's easing, while consumers (most of whom are middle class and hold little or no risk assets) are shortchanged. This matters in America, where consumption is 70% of the economy. One can see why QE 1, 2 and perhaps soon to be announced 3 haven't and won't boost economic growth that much. With the QEs, the Fed giveth, and it taketh away. The net gain to the economy is unclear.

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