Federal Reserve & Interest Rates

Commodity prices, especially oil took a nose dive over the summer as sagging world wide demand finally took it’s toll on a speculative bubble which had built up since the fall of 2007.  After falling to the mid-thirties, the price of oil is starting to slowly creep back up.

As everyone knows, the U.S. is building up an extraordinarily large amount of debt during the current financial crisis.  To finance that debt, they will have to sell an unprecedented amount of Treasury securities.

Treasuries have been a safe haven for wary investors the past few months but the amount of Treasuries about to enter the market has many people worried.  All the money the government is spending can’t help but add inflationary pressure to a commodity market that took a beating in the last six months.

Sometime in the next few months, I wouldn’t be surprised if commodities started making a comeback.  Despite the recession gripping the world, commodities could become a safe have again if inflationary pressure builds too much.

Now this doesn’t mean the Fed will raise interest rates anytime soon but they are definitely keeping an eye on commodity prices.  As long as prices stay fairly low, they can continue to inject liquidity into the financial system through their balance sheet operations.

The key is timing, when the economy starts to improve, the Fed will have to tighten it’s monetary policy fairly quickly, otherwise commodity prices could quickly get out of control again like it did last year.

The Producer Price Index numbers(PPI) released today by the Department of Labor showed that prices for finished goods fell by 2.8% in the month of October.  The rapid decline in energy prices since July caused the biggest one month decline in the PPI ever.

The index for finished energy goods moved down 12.8 percent in October following a 2.9-percent decline in September.  Gasoline prices dropped 24.9 percent after falling 0.5 percent a month earlier.  The indexes for liquefied petroleum gas, diesel fuel, and residential electric power also decreased more than in the prior month. 

Prices for asphalt and finished lubricants turned down in October.  By contrast, partially offsetting the faster rate of decline in finished energy goods prices, the index for residential natural gas moved down 5.9 percent compared with an 8.2-percent decline in September.  Prices for home heating oil also fell less than in the previous month.

It’s been a roller coaster ride for oil since last fall, prices began to rise steadily, surpassing the $100 threshold at the beginning of the year and reaching a peak in mid-July close to the $150 mark.  However, oil’s fall from it’s lofty heights has been even faster than it’s meteoric rise.

For nearly a year much of the world was concerned over skyrocketing energy and food prices and the inflationary pressures it placed on other sectors.  Now the opposite is true as economies begin to shrink across the globe.

While many people are welcoming the lower gas prices once again, the sharp fall in prices alludes to a growing problem the economy is facing, falling demand.  The major concerns going into next year will be deflation and the steadily rising unemployment rate.

Many industries are facing an uncertain period where their very survival could be at stake.  The auto industry never really fared too well even in good economic times.  In the current climate, it faces bankruptcy which will mean the loss of millions of jobs. 

There are also conflicts on how best use the second half of the $700 billion rescue package.  The Treasury has put a band aid on the financial system for the time being but the list of troubled areas keeps growing.

One of the fist acts of the new administration will likely be the passage of a new stimulus package which some are estimating will be over half a trillion dollars.  Whether it will be enough to spur demand remains to be seen.

The price of crude oil has continued it’s downward trend into September as Mother Nature and foreign conflicts have only been able to stall it’s decline over the past three weeks.  We saw oil try to rally on a couple of occasions since it fall from it’s mid-July record of $147.

The outbreak of hostilities between Georgia and Russia which put at risk a major oil pipeline only caused a minor hiccup.  Fears of offshore drilling disruptions from Hurricane Gustav saw oil prices shoot up $6 dollars in one day only to fall by the same amount the following trading session.

The rise of the dollar has played a large part in the general retreat in the commodities market.  After falling to record lows that coincided with oil’s record highs, there is a real feeling that we could be seeing the dollar beginning a period of renewed strength.

This a highly volatile market with large movement swings happening in both direction.  We could easily see oil try to rally again if hurricane activity threatens the Gulf Coast drilling sites.

The same could be said about the dollar, no one knows how it will react in the upcoming months and if it starts to fall again we could see a lot of traders jumping back into commodities.  Analysts are carefully watching the European markets, as long as their economic growth lags behind ours, the dollar should gain in strength.

Central banks will also play a major role as the relative interest rates of each country are a large factor in exchange rates.  At the moment the Fed is more interested in economic growth, while the EU has maintained it stance against inflation, as for Japan, their interest rates are even lower than ours.

Has the oil bubble burst for good?  You still have a lot of traders out there who think oil can recover and break $150 by the end of the year.  Hopefully it will fall to $80, which oil producers believe should be it’s normal price range.