Further Evidence of the Influence of Energy on the U.S. Economy - Part 2
This is a guest post from Steve from Virginia. Steve's real name is Steve Ludlum.
Last week, Dave Murphy (EROI Guy) explored how increasing energy prices during the run up to 2008's $147 bbl peak affected purchasing power of consumers and subsequently the solvency of the establishment that relied on that purchasing power. He mentions James Hamilton:
Hamilton acknowledges early on in his report that the proportion of income spent on energy is an important determinant of consumer spending patterns. The theory is fairly simple: if energy expenditures rise faster than income, then the share of income for other things besides purchasing energy must decline, such as spending on mortgage payments for a second home in Las Vegas. In other words, rapid, large increases in energy prices may curtail consumption enough to trigger larger financial problems – like the bursting of a housing bubble – that when aggregated across an economy may cause or contribute significantly to a recession.
I will show an even greater connection between energy prices, interest rates, and the financial sector, based in large part on a review of minutes of the Federal Reserve Open Market Committee (FOMC) from the end of 2002 to 2007. It appears the Fed’s inflation expectations were very closely linked to petroleum prices. Because of this, the rise in oil prices led the Fed to raise interest rates in an attempt to control inflation, which in turn had unintended consequences.
The US and the world's finance system uses an operating approach called Structured Finance. This is a system for the management of credit using assets such stock and real estate as collateral for highly leveraged lending. The products of this lending are 'Structured' into securities. This finance system makes money by borrowing funds at low rates such as LIBOR + 1 percent (2.5%) and lending at higher rates such as 6%. The system keeps the difference.
Here is a graph illustrating the relationship between the Funds target rate which represents the lowest- cost borrowed money and the 30 year conventional mortgage rate.
The difference or spread between the funds and mortgage rates at any given time represents return to the finance system. When the spread narrows as it did from 2005 - 2007, there is danger to the system. Rates follow a 'yield curve': lowest rates are short term and the higher rates are longer term. There is substantial risk that the system may be 'underwater' if short term rates rise after longer term loans are made at a low rate. The return from the longer termed security is inadequate to service the system's short-term money costs.
Structured finance is organized around the flow of funds. It applies the pricing effect of 'velocity of money' to capital assets rather than to consumables. Velocity of money is the rate of turnover of transactions within any given place and time. Repeat transactions have the same effect as a proportionate increase in the money supply. This effect was observed and described as the 'Quantity of Money' theory by Irving Fisher, derived from Ludwig von Mises, John Stuart Mill and originating with Copernicus:
If changes in the quantity of money affect prices, so will changes in the other factors—quantities of goods and velocity of circulation—affect prices, and in a very similar manner. Thus a doubling in the velocity of circulation of money will double the level of prices, provided the quantity of money in circulation and the quantities of goods exchanged for money remain as before ...
Raising the price of small items by virtue of everyone in town buying them repeatedly requires pocket change. Raising the price of millions of houses by tens or hundreds of thousand of dollars each or raising share prices of gigantic multinational corporations requires tremendous financial horsepower -- which is the end purpose of structured finance. By raising asset prices, collateral values are also raised. This allows more lending against that increase in collateral -- which then drives prices even further in a virtuous cycle.
Clever American financiers invented a sort of financial perpetual motion machine.
The Funds rate is a target set by the Federal Reserve system which is tasked with managing the nation's money supply. Its most important role is to control inflation. Eight times a year, the Federal Reserve Open Market Committee (FOMC) which is made up of the seven members of the Board of Governors, the president of the New York Fed and four presidents of other Fed system banks meets in Washington to examine the performance of the economy and set short term interest rate targets. Records are published of these meetings and made public. These records are available online and a relevant summary is also posted on my blog.
Figure 2 illustrates the Fed's response to inflation by its raising short-term interest rates. Increases act as a governor on demand by increasing the cost of credit. In recessionary periods, the Fed decreases credit rates in order to stimulate lending. The 'Open Market Desk' at the New York Fed performs this job by trading Treasury securities to commercial banks.
The background of our current situation lies in the remarkable period prior to 2002. Fed Governor (at the time) Ben Bernanke mentioned this period in remarks given in 2004:
Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation "the Great Moderation." Similar declines in the volatility of output and inflation occurred at about the same time in other major industrial countries, with the recent exception of Japan, a country that has faced a distinctive set of economic problems in the past decade.
A component of this Great Moderation was low and stable petroleum prices.
As can be seen, from 1990 until the end of 2001, energy prices remained within a volatility range between $20 - 25 with short periods lower or higher. The average price for the period was $21.04.
Energy prices and interest rates have a lengthy historical relationship. Figure 4 plots short term interest rates from 1955 alongside US recessions with energy prices in constant 1982 dollars.
The Fed is careful to watch energy prices as price increases directly contribute to inflation. As can been seen in the plot, rising interest rates and energy prices have preceded US recessions since 1973. Even the 1991 'Mystery Recession' was accompanied by a spike in energy prices after Iraq's invasion of Kuwait.
During FOMC meetings from 2003 - 2006 the committee cited rising energy prices and the inflationary effects of this rise at almost every meeting. Beginning in 2004, the Fed steadily increased the Funds rates starting in June. The year over year increase in energy cost can be seen in Figure 3: 2002 average price was $26.11, 2003 average was $31.12 and the 2004 period was set to average $41.44. This remark from the December 29, 2002 meeting is typical of the period. Note that the Fed uses different methods to gauge inflation:
Core consumer price inflation, as measured by the consumer price index (CPI) and the chain-weighted personal consumption expenditure (PCE) index, continued to edge lower through the end of the year. However, the sizable run-up in energy prices last year boosted overall consumer price inflation somewhat on a year-over-year basis. At the producer level, core prices for finished goods declined in November and December, but for the year as a whole the jump in energy prices pushed overall producer prices for finished goods up slightly. (Per- barrel price at the time of the meeting was $29.46) http://www.federalreserve.gov/fomc/minutes/20030129.htm
Overall inflation in 2003 was low with the exception of a steady rise in energy prices that are noted in all but one of the FOMC meetings. The Funds rate for 2003 was an extraordinarily accommodative 1.25 - 1%:. :
Total twelve-month consumer inflation was unchanged over the period owing to accelerations in food and energy prices. ($43.15) http://www.federalreserve.gov/fomc/minutes/20031209.htm
Total consumer price inflation, however, was boosted in January by a surge in energy prices.($36.75) http://www.federalreserve.gov/fomc/minutes/20040316.htm
In the United States, the core consumer price index advanced at a faster rate in the first quarter than it had in the fourth quarter, reflecting the pass-through of higher energy prices and a leveling off of goods prices after sizable declines last year. ($40.28) http://www.federalreserve.gov/fomc/minutes/20040504.htm
At the June, 2004 meeting the Governors voted to increase rates by 0.25%. They would do so at each subsequent meeting.
In light of the strength of economic activity and recent indications of somewhat increased price pressures, the members focused particular attention on the outlook for inflation. They referred to statistical and anecdotal evidence that on the whole pointed to some recent acceleration of consumer prices and to some increase in near-term inflation expectations. Factors cited in this regard included large increases in prices of energy and intermediate materials, both of which appeared to be passing through at least in part to core consumer prices. ($38.03) http://www.federalreserve.gov/fomc/minutes/20040630.htm
A year and a half later, in February 2005, the acceleration of inflation was an increased concern. Energy- cost for that year would average $51.62 a barrel. Rate increases had not slowed the increase in fuel prices but begun to constrain housing, which is credit sensitive. The emphasis at meetings was on sharply higher crude oil prices. The first hints of softening in the housing sector was noted in February 2005:
Moreover, the recent rebound in spot crude oil prices, and especially the substantial advance in prices of crude oil futures contracts for delivery well into the future, suggested that a significant unwinding of higher energy costs might not be in prospect. Several participants indicated that, in current circumstances, they viewed an upside surprise to inflation as potentially more harmful than an equivalent downside surprise, partly because such an outcome could well impart additional upward momentum to inflation expectations. ($54.19) http://www.federalreserve.gov/fomc/minutes/20050322.htm
In August, Katrina had hit the Gulf coast and its effects were noted in the minutes along with consequential energy price increases. Participants questioned the effect of higher energy prices on business investment. Inflation was a concern. The Funds rate was 3½ percent:
Participants' concerns about inflation prospects generally had increased over the intermeeting period. The surge in energy prices, in particular, was boosting overall inflation, and some of that increase would probably pass through for a time into core prices. This posed the risk that there could be a more persistent influence on inflation should inflation expectations rise. Indeed, some recent survey evidence on such expectations had been troubling, and widening federal deficits were mentioned as a factor that could further stir inflationary concerns. ($65.59) http://www.federalreserve.gov/fomc/minutes/20050920.htm
By the end of 2005 the increase in oil and energy prices had become a preoccupation of the Federal Reserve. The end of 2005 turned out to be the peak of the housing bubble: The funds rate had increased over the year from 2.25 to 4%. Here, the Fed makes one of its rare acknowledgments of the effects of its interest rate increases on housing:
Activity in the housing market remained brisk despite a rise in mortgage interest rates. Starts of new single-family homes dropped back somewhat in October from September's very strong pace, but permit issuance remained elevated. New home sales reached a new high in October, and existing home sales eased off only a little from the high levels recorded during the summer. Other available indicators of housing activity were on the soft side: An index of mortgage applications for purchases of homes declined in November, and builders' ratings of new home sales had fallen off in recent months. In addition, survey measures of home buying attitudes had declined to levels last observed in the early 1990s. ($59.41) http://www.federalreserve.gov/fomc/minutes/20051213.htm
At the January 31, 2006 meeting, there was more comment on interest rate effects on mortgage lending. Keep in mind that loan originations are by non- bank businesses that do not report to the Fed: After this meeting, Ben Bernanke replaced retiring Alan Greenspan as Fed Chairman:
In some areas, home price appreciation reportedly had slowed noticeably, highlighting the risks to aggregate demand of a pullback in the housing sector. For instance, the effects of a leveling out of housing wealth on the saving rate were difficult to predict, but, in the view of some, potentially sizable. Rising debt service costs, owing in part to the reprising of variable-rate mortgages, were also mentioned as possibly restraining the discretionary spending of consumers. ($65.49) http://www.federalreserve.gov/fomc/minutes/20060131.htm
In subsequent meetings during 2006 the steady rise in energy prices was noted: "registering a large increase in January that was driven mostly by a spike in energy prices.", "retail gasoline prices surged, leading to a jump in overall energy prices for the month", "sharp increases in the prices of petroleum-based products". At the July 29, 2006 meeting the funds rate was raised 5¼%. At this point, FOMC meetings contained two narratives, the steady increase in fuel prices and the ongoing deterioration in the housing sector:
In their discussion of the major sectors of the economy, participants observed that housing construction activity had declined notably in recent months as indicated by lower housing starts and permits; moreover, higher inventories of unsold homes, a sharp rise in cancellations of new home sales, and reports from construction companies suggested that the weakness was likely to be extended. Several participants pointed out that the decline was broadly in line with expectations in light of the tightening in monetary policy and the rapid run-up in home prices and residential construction in recent years. Participants also observed that the evidence to date indicated that the slowdown was orderly but were mindful of the possibility of a sharper downturn in the sector.
The growth of consumer spending had dropped off significantly in the second quarter from a robust pace earlier in the year. The slowdown was attributed in part to higher energy prices and also to a likely downshift in home price appreciation and higher interest rates. A reduction in the attractiveness of home equity borrowing was mentioned as possibly contributing to the slowdown. ($70.95) http://www.federalreserve.gov/fomc/minutes/20060629.htm
At the Treasury Department, the likelihood of a displacement was under discussion as early as 2005. The focus was both the effects of rising rates as well as a fuel price spike:
Secretary Paulson on this arrival in summer 2006 (DATE) told Treasury staff that it was time to prepare for a financial system challenge. As he put it, credit market conditions had been so easy for so long that it was inevitable that credit problems had built up that would lead to problems if conditions reversed.
From summer 2006 Treasury staff had worked to identify potential financial market challenges and possible policy approaches, both near term and over the horizon. The longer-range policy discussions eventually turned into the March 2008 Treasury Blueprint for Financial Markets Regulatory Reform that provided a high-level approach to financial markets reform. Consideration of near-term situations included sudden crises such as terror attacks, natural disasters, or massive power blackouts; market-driven events such as the failure of a major financial institution, a large sovereign government default, or huge losses at hedge funds; or slower-moving macroeconomic developments such as energy price shocks, a prolonged economic downturn that sparked wholesale corporate bankruptcies, or a large and disorderly movement in the exchange value of the dollar that led to financial market difficulties. None of these were seen as imminent in mid-to-late 2006, and particularly not with the magnitude that would eventually occur in terms of the impact on output and employment. http://www.econ.yale.edu/seminars/macro/mac08/Swagel-090409.pdf
That impact would be considerable; in February, 2007, Freddie Mac stopped accepting certain sub-prime mortgage securities for purchase. The crisis was officially underway: A barrel of West Texas Intermediate in Cushing, Oklahoma cost $59.28. http://timeline.stlouisfed.org/index.cfm?p=timeline
A number of conclusions can be drawn from these documents. One is that energy contributed to Fed actions. Another is that the current crisis has developed similarly to other US recessions. Even the geopolitical background - Mideast tension and war - is similar to other recessionary periods. The sequence of events is:
A rise in energy prices -> increased inflation -> higher short term interest rates -> a slowdown in credit-sensitive sectors of the economy such as housing and lending -> a general slowdown in the economy as a whole.
Mr. Bernanke outlines the sequence in his 'Great Moderation' address quoted previously. The large difference this time compared to other 'energy crises' is that there are no gas lines or odd-even rationing which would focus public attention on energy rather than on finance. In the past, inflation was constrained by punishingly high short term money costs along with new petroleum supplies introduced from North Sea and Prudhoe Bay sources. Currently, inflation has been constrained by punishingly high energy costs. The yearly average price for crude in 2008 was $90.89! This would imply short term rates of 15.25%.
Oil from a new North Sea or North Slope does not appear available, today. The current year (2009) average is a relatively inexpensive $42.91 for the first three months. What is troubling is the absence of the mention of energy anywhere in the public discussion. Outside of relatively obscure records of Fed policy making, it is difficult to find 'oil prices' or even 'interest rate increases' in statements or announcements by either the Federal Reserve, its officers or the Treasury. I will leave to others whether this absence is in the public interest.
A significant difference between the current crisis and recessions past has been the growth of and reliance upon structured finance. An "unintended consequence" is its demonstrated vulnerability to what has to be considered a routine increase in short-term interest rates.
The housing bubble and the follow-up 'petroleum bubble' illuminates one flaw--it works too well! It inflates asset prices to levels unsupportable by fundamentals. One reason for the 2008 oil price acceleration was the flow of funds or quantity of money' effect on the fuel market. The turnover or velocity of transactions in both the spot and futures markets by hedge funds and other structured finance participants had a large inflationary effect. As in housing, once the velocity of transactions slowed - due to unsupportable pump prices stifling demand - the inflating effect of the turnovers was removed and prices reversed.