The Fed’s Magical Thinking

I woke up to a strange headline in the Wall Street Journal yesterday: “Oil’s Run to $100 Tests Fed.”

Wondering what $100 a barrel of oil had to do with the Federal Reserve, I read further. The Journal’s concern was that $100 oil would endanger the Fed’s chance of bringing about a “soft landing,” killing inflation without causing a recession.

The Journal warned that high oil prices would keep inflation elevated and that would force the Fed to keep interest rates elevated or even raise them further.

At no point did the Journal’s reporter, David Uberti, give any indication that he was doing anything other than stating the obvious. Nor, presumably, did his editor challenge the utter conventionality of this view, apparently so universally accepted that Uberti’s article ran in the news section right there on B1, the front page of Business and Finance, rather than as an opinion piece.

Yet, it is an extremely strange idea on several counts.

The piece was accompanied by several graphs, each really in support of the same point, which was that the common measures of inflation, “all items” or “core,” have lately been quite subdued, while the lines depicting oil prices were nearly vertical. The implication being that high oil prices mean the Fed has not got inflation licked.

This is the first strange idea. Although the monetarist theory of inflation has failed the test of time (despite Joseph Stalin’s passionate adherence to it), Milton Friedman’s dictum holds true: Inflation is always and everywhere a monetary phenomenon. This is true by definition What we mean by inflation is not a rise in this price or that price, pork bellies are more expensive while sorghum (and just what is sorghum anyway?) is cheap. What we mean is a fall in the value of a dollar. That core inflation is sedate while oil goes through the roof does not suggest that oil is rising because the dollar is falling.

From 2019 through 2020, the value of the dollar did fall a great deal compared to the most reliable measures, such as gold, silver or a basket of commodities. In early 2019, an ounce of gold could be had for $1,400. By 2021, that gold would cost you almost $2,100. Since then, despite some volatility, the price has hardly moved. It stands at a little less than $1,920 as I write.

Below is a graph from the St. Louis Fed for the price of gold ores. It does not show actual dollar prices, but an index price with the 1985 price set as an index. The same point is made. A graph of the dollar against a basket of precious metals, or commodities, would show roughly the same pattern.

Gold is not a perfect measure. And even true inflation will work its way through the economy fitfully, raising one price now, another later; one more, another less. Still, the rough conclusion holds. We had genuine inflation, a severe loss in the value of the dollar starting in mid-2019 and ending in mid-2020. Then it stopped. Since then, the dollar has gained back a bit less than half the value it lost in 2019 and 2020.

Neither the loss of value nor the partial repair can be readily blamed on or credited to the Fed. Interest rates for all of 2019 well into 2020 were higher than for most of the preceding 10 years. And the Fed did not begin to raise rates until March 2022.

In any event, the recent price of oil has nothing to do with any of this. Let’s see. We had a global pandemic, we have the largest war in Europe since 1945, and a basic tactic of that war has been to reduce imports of Russian energy. The U.S. government has been doing everything it can to impede fossil fuel production, and Saudi Arabia has decided to flex its OPEC muscles in part because its leaders despise Joe Biden. That’s why oil prices are rising at a multiple of so-called core inflation: we don’t have enough of the stuff.

Still, the Journal warns that high oil prices could mean higher food prices and even higher everything prices because you need, you know, fuel to move stuff or even plant and harvest stuff.

It  is right to worry. One supply shortage leads to another. But the notion that the Fed can help is the most confused idea of all.

For just a moment, let’s put aside magical Fed thinking and ask a simple question: How will raising interest rates or keeping them high increase the supply of oil? By making oil rigs more expensive to finance? By easing the finances of exploration and development firms? By squeezing the margins on refiners and distributors?

That’s the strangest idea of all.

Rising rates will suppress production and supply. They may also put a lot of people out of work and drive a lot of businesses bust. And yes, when businesses and people are poor, they won’t be able to buy things and prices may come down. But trying to solve a supply crisis by collapsing production and impoverishing the people is as foolish as it is wicked.

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