By: Phil Kernen
Over the last four decades, one strength of Federal Reserve leadership has been emphasizing energy prices for their impact on economic growth and inflation potential. That focus and willingness to act preemptively are material reasons inflation has been so low for such a long period. In our current inflationary environment, our most significant concern about the path of future interest rates stems from further upward pressure on energy prices and the willingness and ability of the Federal Reserve to react.
In the 1970s, energy prices rose due to geopolitical factors, contributing to inflation steadily growing across the decade and into the 1980s. The Fed eventually responded by raising interest rates to a high enough level to reduce demand and stabilize prices. The accompanying recessions were painful but necessary.
Subsequent Fed leadership acknowledged the cost of persistent inflation, the higher interest rates needed to fight it, and its hard-earned inflation-fighting credibility. Later economic expansions that included higher energy prices produced reminders about the importance of addressing those increases before they broadened.
In 2006, Federal Reserve Chairman Ben Bernanke gave a speech to the Economic Club of Chicago explaining the rising energy costs experienced over the prior years. He talked about first-order effects – higher oil prices leading to higher prices for refined products such as gasoline and heating oil. He also discussed second-order effects derived from higher energy prices – when firms pass on higher production costs in the form of higher consumer prices for non-energy goods and services.
Think of a marine oil spill. If the drilling company contains the escaping oil to the immediate area before capping the well, they can limit the extent of the damage to first order effects. But if enough escaped oil creates visible slicks on the surface or spreads to the shoreline, the damage has reached second-order effects, and the resulting fallout will be much worse. With inflation, the risk of broadening second-order effects is that consumers increase their inflation expectations in tandem.
The derivative impact of energy costs explains why inflation data calculates in two ways. Headline inflation includes everything, and core inflation excludes food and energy. Because energy and food prices are more volatile, headline inflation numbers are volatile too. Rising energy prices that remain elevated over a sustained period lead to the second-order effects that impact core inflation materially. When inflation becomes embedded in core prices, consumer and business expectations for future inflation rise, leading to further increases and an inflation spiral
Today energy prices are again high worldwide. Demand is growing, but the three largest producers, the U.S., Saudi Arabia, and Russia, are only maintaining rather than increasing production levels. U.S.-based producers are unwilling to make additional long-term investments totaling billions of dollars under an administration whose idea of energy independence means a faster transition towards renewable energy and away from carbon-based energy. Announced releases from the Strategic Petroleum Reserve won’t cover the gap.
Despite repeated requests from western leaders, Saudi Arabia will only increase production moderately, saying the gap between supply and demand is narrowing, and today’s high prices reflect panic by oil buyers. Other OPEC nations find it hard to increase production due to lower investment during the pandemic. And Russia wishes to keep energy prices high to fund its military operations in Ukraine.
Today inflation expectations have risen and are at risk of going higher. According to the N.Y. Fed Survey of Consumer Expectations, one-year inflation expectations were 6.3%; three-year expectations rose to 3.9%. While these results remain lower than current inflation, climbing expectations suggest that consumers see higher prices in their daily purchases and recognize that higher energy prices are transmitting themselves through the larger economy.
Over the last two years, the Fed funded the largest fiscal expansion in U.S. history. In the process, it reduced its independence and allowed itself to become more politicized. Because of its slow initial response, it faces a broadening of second-order effects from higher energy prices and is at risk of losing its fight against inflation.