Federal Reserve & Interest Rates

Oil continues it’s meteoric rise this year as it passed the $135 a barrel mark earlier today.  The debate has been raging whether the high prices are the result of a speculative bubble or normal supply and demand interaction.

I believe it is a combination of both factors.  World wide demand has grown sharply the past few years as the developing countries become more and more industrialized.  That being the case, that still doesn’t justify the more than 30% rise in the price of oil for this year alone.

Last summer, oil was trading at around the $60 a barrel range before the Fed began it’s rate slashing campaign and the dollar took a nose dive.  This put a large upward price pressure on all dollar denominated assets. 

Money started pouring into the commodities markets as inflation hedges at the beginning.  When the stock and bond markets started falling, the commodities market offered better returns and large institutional investors also started to enter the fray.

But as world wide economic activity has slowed due to the global credit crunch, demand for oil has fallen somewhat, but the price of oil has continued to rise.  While some of this is due to inflation, that would still only justify somewhere between 5-10% of the price rise since last summer.

The price of the dollar is the key to the price of oil.  While the administration is supposedly in favor of a “strong” dollar policy, the Fed’s top priority remains economic growth with inflationary concerns a distant second.

That mind set may be slowly changing and it would be interesting to see what effect a rise in interest rates would have on the price of oil.

On Tuesday, the Labor Department released it’s numbers for the Producer Price Index(PPI) for the month of April.  The price of finished goods rose .02%, while economists were predicting a .04% rise, a sharp drop off from the 1.1% increase in March.

While on the face of it the numbers look favorable, core PPI which excludes food and energy prices, rose .04% which was higher than expected.  These numbers fuel the growing fear that inflation may be creeping into other sectors of the economy.

Food and energy prices had a relatively flat month after soaring in March.  Much of that can be attributed to the general consensus that the Fed would ease it’s aggressive stance on interest rates, thus slowing the fall of the dollar in currency markets.

However, while food prices have stabilized somewhat, oil prices continue to hit record highs this month, with many analysts predicting it will surpass $150 a barrel before the end of the year.  While economic growth is still sluggish and financial markets have yet to recover, there may be increased pressure on the Fed to raise rates in the near future.

If that were to happen and the dollar starts to rise, it could spur profit taking from commodities traders and send the price of oil falling toward the $100 a barrel mark.  The other central banks of the world have resisted lowering rates in the face of slowing economic growth which has had a negative impact on the price of the dollar.

It will be a tough balancing act for the Fed and while economic growth remains their top priority, rising inflation is becoming more and more of concern. 

Financial institutions were making a lot of money a few years back when credit was cheap and the housing market was booming.  Their risk profiles grew as they sought ever higher profit margins.

Their basic strategy was to originate loans and then repackage them into asset backed securities to sell to investors.  The cash received from the securities would then be used to originate more loans as the cycle continued.

Fed Chairman Ben Bernanke discussed the risk management of financial institutions and the underlying causes of the credit crunch at a conference on bank structure and competition earlier this week.

The revenues of the originators of subprime mortgages were often tied to loan volume rather than to the quality of the underlying credits, which induced some originators to focus on the quantity rather than the quality of the loans being passed up the chain. However, the problems with subprime mortgage underwriting were disguised for a time by the continued appreciation in home values.

As long as house prices kept rising, subprime borrowers saw their home equity increase and were often able to refinance into more-sustainable mortgages. But when house prices began to stagnate and then fall, many subprime borrowers found themselves trapped in mortgages they could not afford. Because subprime loans were frequently securitized and incorporated into complex structured products, the resulting losses spread throughout the financial system.

Financial institutions were selling these high risks loans as securities to unsuspecting investors, yet they were also taking huge losses.  That’s because they exposed themselves to their own risky loans through the explosion of the derivatives market and credit default swaps in particular.

The highly leveraged system of credit, valued in the trillions was only backed by a fraction of that in real capital.  The entire financial system essentially became a house of cards that eventually collapsed under it’s own weight, once the rising housing prices which supported it became a distant memory.