TCS Daily


How Transitory Are Mr. Greenspan's 'Transitory Factors'?

By Desmond Lachman - July 30, 2004 12:00 AM

Among Federal Reserve Chairman Alan Greenspan's bolder assertions in his semi-annual report to Congress on July 20 was that the observed softness in US consumer spending of late should prove to be short-lived. This view was based on the notion that the recent pick up in US inflation and the corresponding erosion in household disposable income was due to "transitory factors such as the surge in energy prices." For the sake of the global economy, one must hope that Mr. Greenspan is right. However, if present developments in the Middle East and in Russia are anything to go by, one must also hope that Mr. Greenspan stands ready to take a softer line on interest rates if the recent run-up in energy prices proves to be more than a transitory phenomenon.

At the crux of the matter has been the sharp run-up in international oil prices over the past six months. Whereas at the start of the year WTI light oil prices were at around US$32 a barrel, today they trade with more than a US$42 a barrel handle. According to IMF calculations, a sustained US$5 a barrel increase in international oil prices adds 0.3 percent to US core inflation and subtracts around 0.4 percent from US GDP growth. This could well mean that if oil prices were to remain at US$42 a barrel, US growth in the second half of the year would be around 0.8 percent below the level that it might otherwise have attained.

In gauging the likely future impact of higher international oil prices on the US economy, one needs to be mindful of the fact that the US economy has already probably slowed in the second quarter of the year to around 3 percent, or to a rate that should make the Federal Reserve more relaxed about the risk of inflation. In addition, one also needs to recall that aside from higher oil prices, the economy is being subjected to two significant policy shocks.

First, the economy has still to adjust to the100 basis points rise in long-term US interest rates since April when the Federal Reserve suggested that short-term interest rates would need to be increased at a "measured pace." This is already abruptly slowing the pace of mortgage refinancing that previously supported household spending. Second, the economy has to adjust to the fading out of the sizeable tax refunds in the second quarter, which up until now have been an important support to disposable incomes. These factors increase the likelihood that the US economy will grow at below its potential 3.5 percent rate in the second half of the year should oil prices not decline fairly soon from today's present levels.

Evidently Mr. Greenspan believes that international oil prices will decline fairly steadily in the second half of the year. However, one has to ask whether one can be quite so sure that this will indeed be the case. Is the International Energy Agency not telling us that world oil inventories are at very low levels and that spare capacity is all but absent in the major oil producing countries? Is there not the real risk of further significant oil supply disruptions not only in a very troubled Middle East, but also in countries like Nigeria, Russia, and Venezuela that are presently embroiled in their own political turmoil? One need only contemplate President Putin's dangerous showdown with Yukos, the Russian oil giant that produces 1.8 million barrels a day, to realize that high international oil prices might not just be a passing phenomenon.

In view of the US economy's present soft patch and of the uncertain global energy outlook, Mr. Greenspan would be well advised to keep an open mind as to what the data might inform him about the future direction of the US economy. In particular, should energy prices remain stubbornly high and should the economy's soft patch prove longer lasting than presently expected, Mr. Greenspan would do well to raise interest rates at a less rapid pace than the markets are presently anticipating. For it is not only the health of the US economy that is riding on Mr. Greenspan's making the right interest rate decisions but that of the global economy.

The author is Resident Fellow, American Enterprise Institute.


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