Monday, December 17, 2007

The Greenspan Effect

I was struck by a comment on energy from former Federal Reserve Chairman Alan Greenspan last week. As quoted in the weekend Wall Street Journal, he said, "The notion of core pricing is fading in importance as: One, food prices driven by increased long-term demand for meat and milk rise with the growth of China and other developing countries, and as; Two, global oil supply peaks lower and sooner than has been contemplated earlier." You could write a dissertation for a Ph.D. in economics based on that sentence. In one thought, Mr. Greenspan suggests that measuring inflation without factoring in energy price increases is an outdated notion, and that high energy prices are likely here to stay. The absolute accuracy of such an assertion may matter less than the market's response to an utterance from someone with such impeccable credibility.

I don't know if it says more about Mr. Greenspan's extraordinarily long tenure as at the helm of the Fed, or the qualities of his successor, that many continue to regard him as the preeminent voice on the economy and seek out his views regularly. I don't remember quite the same thing occurring after Mr. Greenspan replaced Paul Volcker, whom many credit with eradicating the high inflation of the 1970s. In any case, Mr. Greenspan still has the knack for encapsulating vast economic trends in a few words, and those words can move markets.

For as long as I can remember, observers of the economy have focused on core inflation, excluding food and energy prices, as the key measure of price stability. Until recently, the logic of factoring out volatile energy prices was solid, because oil prices always seemed to revert to a long-term average price in the low- to mid-$20s. Since 2003, however, that rationale has broken down. Over the last five years the key indicator of oil prices, West Texas Intermediate crude oil traded on the New York Mercantile Exchange, has gone up by about 30% per annum--with very large spikes and dips around that trend. Substituting the DOE's record of US refiner crude oil acquisition prices, a broader indicator of the raw material cost of fuels, suggests that oil inflation has been running at 25%. Natural gas isn't far behind, with roughly an 18% inflation rate on wellhead prices since 2003. Mr. Greenspan's remarks recognize that you can't double energy costs every three or four years without swamping many of the other economic factors that the Fed and economists monitor. And as I noted the other day, the alternative energy supplies being promoted by US energy policy are unlikely to provide any price relief.

Mr. Greenspan apparently doesn't envy the task his successor now faces: simultaneously trying to stave off a recession, defend the value of the dollar, and protect against the reappearance of serious inflation, driven by the very factors that the core inflation rate ignores. This may not fit the classical definition of a liquidity trap, but it could be the practical equivalent of one, if the Fed can't reduce interest rates much further--or even if the market merely believes that to be true, validated by voices such as Mr. Greenspan's.

What does that mean for all of us non-economists? Well, for starters, it shifts the burden of averting a recession away from interest rates and toward tax cuts and other fiscal policies--hardly the flavor of the week in a Congress seeking new revenue to offset the cost of new programs and shrink the federal deficit. At the same time, Mr. Greenspan's endorsement of the idea of an approaching peak in global oil output will tend to keep energy prices high by supporting higher long-dated futures prices. That compounds the Fed's problem and could also lead to higher valuations for oil equities (some of which are in my personal portfolio.) To the degree that this all comes down to market expectations about the future, I can't think of a more credible influence on those perceptions than the former Fed chief.

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