Surprisingly, there is an odd man out when three key economic series − the world price of oil, the U.S. inflation rate and the federal funds rate of the Federal Reserve − are compared with one another. This is shown most clearly in the accompanying two graphs.
An analysis of this phenomenon leads to the contrarian position that there is a strong argument for moving interest rates higher sooner than might otherwise be planned.

Amazing Correlation between Oil Prices and Inflation
The first graph that accompanies this report shows year-over-year percent changes for oil and the all-items Consumer Price Index (CPI-U). The vertical scales are not the same, with the amplitude of oil price swings being much greater than for overall inflation. Nevertheless, the degree of correspondence (i.e., the correlation) of the directions of change are amazing. For the entire period plotted, back to January 2000, where oil prices go, the CPI quickly follows.

But Interest Rate Policy Appears to Lag
The second graph below superimposes the level of the Federal Reserve’s federal funds rate on top of the other two series. After all, interest rates are the main tool with which a monetary authority tries to manipulate price change. Admittedly, there is an important role played by interest rates that cannot be captured in a graph and that is the way in which they influence consumer and business psychology.

That is to say, interest rate adjustments up or down influence expectations about inflation and economic growth. Nevertheless, based on absolute levels, it appears that interest rate policy lags what is required by inflationary pressures (or lack thereof) by at least six months. The federal funds rate has dropped lower than necessary at times of expansion and has risen higher than necessary when prices are rising too quickly.

At this present time, the federal funds rate appears to be lower than would be warranted by both the oil price change and the all-items CPI change. There is a strong case to be made for moving interest rates higher despite the weakness in the economy.

Exaggerated Speculative Swings are Altering the Cycle

This proposition rests on the theory that weakness in the economy is no longer just a cyclical phenomenon. It is partly the end-result, over several years, of speculative swings. This first occurred in housing markets, which led to the sub-prime mortgage collapse, and is now manifest in commodity prices. Specifically, high gasoline prices are causing consumers to be extra cautious and this is slowing down economic expansion. The question is one of how to break out of this pattern?

Add Money back into the Asset Mix
The speculative swings are occurring because there are a limited number of asset classes in which to invest – real estate, the stock market and commodities. When one goes sour, another rises to the fore. Commodities are the current hot spot for risky investments. Higher interest rates would throw another asset class − money − back into the mix. It would provide an incentive to put earnings and investment funds into savings accounts and bank certificates, thereby relieving some of the pressure on oil prices.

A Self-defeating Aspect to U.S. Interest Rate Policy

Furthermore, there has been a self-defeating aspect to U.S. interest rate policy when it comes to oil prices. The world price of oil has been moving in inverse-relationship to the value of the U.S. dollar. In other words, the prices of oil and several other commodities (e.g., gold) have become a hedge against U.S. dollar declines. The value of the greenback has been determining commodity prices, rather than the other way around. Therefore, on this count too, a higher interest rate policy would lend support to the U.S. dollar and take some of the pressure off commodity prices.

Finally, it seems that higher interest rates are warranted simply on the basis of the past relationship between the federal funds rate and the percent changes in inflation and oil prices, as shown in the second graph. This may be “eyeball” economics, but it would appear to have some merit.

Member Comments