New Fed fear: Lower oil

NEW YORK (CNNMoney.com) -- The drop in oil prices to the lowest level in 20 months has boosted some investors' hopes that a key ingredient of inflation is out the door, which has helped open the back door for lower interest rates.

That's one of the reasons a surprising jump in a key wholesale inflation gauge caused little stir in financial markets Wednesday, the day before the government's main gauge of inflation, the Consumer Price Index, is due. The wholesale inflation report came the same day that oil dipped near $50 a barrel - down some 35 percent from the record highs hit last summer, and the lowest point since May 2005.

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But the inflation hawks at the Federal Reserve aren't likely to drop their guards - or interest rates - just because $40-something oil might now seem in reach.

Some economists even argue that the Fed will have to be even more vigilant for inflation pressures now that oil is falling. That's because lower oil prices could actually give a boost to consumer spending and the economy, which flagged in the second half of last year under the weight of higher oil prices and the series of rate hikes from the Fed that ended last summer.

It may seem counter-intuitive, but just as higher oil helped slow the economy in 2006 and let the Fed end its course of rate hikes, if oil stays low it could wash way the chance of rate cuts.

Some economists say that oil by itself is too volatile a commodity to be a basis for monetary policy decisions - a key reason that the Fed and many other economists focus on the so-called core inflation readings that strip out food and energy prices. And many economists are still expecting an average price of oil for all of 2007 above $60 a barrel, not significantly below last year's average of $66, especially if there is more geopolitical upheaval in the Middle East.

Even if those forecasts are wrong and oil stays close to the $50 mark it neared early Wednesday, that could actually spur growth, and raise inflation pressures, according to some experts.

"There's no reason for the Fed to stimulate this economy with interest rate cuts," said Bernard Baumohl, managing director of the Economic Outlook Group, a Princeton, N.J., research firm. "The U.S. economy is accelerating on its own due to drop in oil prices and rising wages. The Fed will have to be very careful what is going to happen on inflation front."

Baumohl said he now sees almost no chance of a Fed rate cut this year, and a growing chance of at least one rate hike by the end of 2007 to cool off economic growth.

"There are three reasons for the drop in oil prices and all are likely temporary," he said. "Certainly the warmer weather is a contributing factor. The Saudi comments that there's no reason for OPEC to have an emergency session to cut production is another. There could be geopolitical reasons for that. And there are large inventories right now."

He said a pickup in the U.S. economy he now expects to see this year, coupled with the start of the summer driving season, will eat away at those inventories and send prices higher.

Baumohl and David Wyss, chief economist for Standard & Poor's, both say that if forecasts are wrong and lower oil prices persist, it could be the equivalent of a tax break, which tends to spur the economy - and could be a concern to inflation watchers at the Fed. Wyss said he doesn't believe the central bank is likely to hike rates, but that's because he thinks the sluggish U.S. housing market will continue to be a drag on growth.

"It (a drop in oil prices) certainly means the Fed wouldn't have to cut rates," said Wyss. "I would see the lift to the economy (from lower oil) as a mitigation of the slowdown, rather than an actual speed up."

Wyss also said that just as record high oil prices in 2006 had relatively little affect on core inflation rates, a drop in oil won't help lower core price pressures.

"Oil is not as big a factor in the economy as it used to be," said Wyss, who said about 5.5 percent on consumer spending was on energy overall, compared to more than 8 percent in the early 1970s. And oil now makes up only about 30 percent of energy spending, compared to 45 percent back then.

"It's not trivial. But households spend a lot less on energy and than they used to," he said, adding that while record high oil prices bled through to other parts of the economy, "it wasn't as much as was expected."

Wyss said he thinks that even if oil stays low, it won't be enough to stir greater inflation fears at the Fed. But he pointed to other issues that he said will concern Fed policymakers, especially if oil stays low.

"Labor compensation is what has the Fed worried," he said. "And if the dollar starts to drop, that's going to raise import prices, and that's very directly inflationary.

"If oil stays low and labor markets stay tight, I think most likely scenario is Fed sits on rates where they are for rest of the year," he added.

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