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Crude awakening for the Fed?
With oil near $70, can Alan Greenspan & Co. keep raising interest rates at a measured pace?
August 29, 2005: 12:24 PM EDT
By Paul R. La Monica, CNN/Money senior writer
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NEW YORK (CNN/Money) - With oil and gasoline prices soaring, it may be tougher and tougher for the Federal Reserve to keep dismissing the effect that oil is having on the economy.

Hurricane Katrina isn't helping matters either. Fears about the storm causing a significant slowdown in oil output in the Gulf of Mexico sent the price of crude above $70 a barrel Monday, though prices later backed off a bit.

In late June, when the Fed raised a key interest rate to 3.25 percent, the central bank said in its statement that "although energy prices have risen further, the expansion remains firm."

The Fed added in the minutes from that meeting that "the economy evidently had been resilient in the face of rising energy prices." At the time, crude oil was trading at about $56 a barrel.

Three weeks ago, following another quarter-point rate hike that brought rates up to 3.5 percent, the Fed said that "aggregate spending, despite high energy prices, appears to have strengthened since late winter." At that time, oil was trading at about $62 a barrel.

Time to pause...

Will these words come back to haunt the Fed? There is growing anecdotal evidence that record-high oil and gas prices are causing a pullback in spending.

And that has sparked a debate among economists about how much further the Fed should raise short-term rates. Some believe the Fed should rethink its pledge to keep raising rates at a "measured" pace.

"When people that are making $150,000 a year are complaining about having to drive the Accord on the weekends and keeping the thermostat at 75, the price of oil's having an impact," said John Norris, chief economist with Morgan Asset Management, a Birmingham, Ala-based institutional investment firm.

As such, Norris thinks that the Fed would be wise to pause once interest rates hit 4 percent. He thinks the Fed will lift rates by another quarter of a percentage point at its next two meetings on September 20 and November 1.

"The Fed's hell-bent on getting rates to 4 percent but after that it needs to take a look at a lot of things," Norris said. "It might be wise to seriously consider stopping."

After the Fed's meeting on August 9, there was a growing sense on Wall Street that the Fed would raise rates at its remaining three meetings this year, which would leave interest rates at 4.25 percent by the end of December.

The minutes from the August 9 meeting will be released on Tuesday and investors will be looking for more clues about how concerned the Fed is about oil.

Regardless of what the Fed says, David Kelly, economic advisor with Putnam Investments in Boston, also thinks that the Fed should take a break after the November meeting in order to determine how much oil prices are affecting the economy.

Kelly argues that the main reason to keep raising rates is to keep inflation in check. But even with oil prices in the mid $60s, there still seems to be little evidence of inflation in other goods and services. So the worry is that the Fed could cause a harsher-than-intended slowdown if it keeps boosting rates when oil keeps rising.

"The Fed knows darn well that higher oil prices increase the risks of a recession more than it does triggering massive inflation," Kelly said. "If the price of oil suddenly crashed and consumer spending were to get better than the Fed might want to go to 4.25 percent but I think 4 percent is the magic number."

...or stay the course?

But some economists believe the Fed does not have to change its plans because of oil prices.

Dan Laufenberg, chief economist with Ameriprise Financial in Minneapolis, said it's important to note that the main reason for high oil prices is because of strong energy consumption, which reflects the basic health of the economy.

That makes this "oil crisis" a lot different than the 1970s, when oil supply shortages sent the price of crude soaring. "It's more important how you get to the higher price than the price itself," Laufenberg said. "The reason that prices are higher is that the world is demanding more oil. And it's not just China and India. It's the U.S. as well."

Bond investors, however, seem to be more concerned about an oil-induced slowdown. The yield on the 10-year Treasury note has fallen from about 4.4 percent three weeks ago to 4.15 percent on Monday. Typically, falling long-term yields are associated with a slowdown in economic growth.

"Bond fund managers don't believe long-term inflation is a significant worry," Morgan's Norris said.

But low long-term rates could actually be helping to allay some of the fears about higher oil prices because they've helped keep mortgage rates attractive enough to keep the housing market strong, said Yanick Desnoyers, senior economist with National Bank Financial in Montreal.

And a strong housing market is another big difference between now and the 1970s. So long as the housing market doesn't collapse, consumers should be able to withstand higher oil prices, according to Desnoyers. "Clearly the real estate wealth effect is offsetting the rise in household energy bills so far," he said.

Desnoyers adds that he's not worried about the slide in long-term rates because he thinks bond investors are just simply wrong to assume that a major slump is in the cards. After all, long-term rates are still lower than where they were when the Fed first started raising rates in June 2004 and the economy has not shown any major signs of weakening. With that in mind, he thinks the Fed will raise short-term rates to 4.5 percent by the first quarter of 2006.

"The bond market is saying that growth won't be as robust as the Fed thinks but if we go back to last year, it's clear the bond market misread the situation," said Desnoyers. "The bond market may be too sensitive to the price of oil and is too quick to pull the trigger on a slowdown scenario."

For a look at the price of oil and other commodities, click here.

For a look at bond rates, click here.  Top of page

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