Worry About the Fed, Not Oil

Larry Kudlow
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Posted: Aug 26, 2005 12:00 AM
Permit me to take a contrarian view on the economic outlook. It’s not the impact of high energy prices or the housing boom that worries me. Rising gas prices and home values represent the forces of good, not evil. My biggest worry is an ever-tightening monetary policy from the Federal Reserve.

On the oil-price shock, I say at least two cheers for higher prices. Why? Because I believe in markets. When the price of energy goes up, demand falls off and supply increases. This is the case today and it represents nothing short of a tectonic shift.

As Dan Yergin, president of Cambridge Energy Research Associates, recently wrote in the Washington Post, rising energy prices today will cause energy supplies to explode tomorrow. With gas prices moving toward $3 a gallon, the public is now even favoring nuclear power -- by two-to-one, according to pollster Scott Rasmussen. Nuclear energy is the ultimate solution for clean power and reduced foreign dependence. And with the government giving the Federal Energy Regulatory Commission the authority to override localities that oppose nuclear power, liquefied natural gas, or other forms of energy, the likelihood of an energy explosion in the years ahead is even greater. Markets work if you let them.

The spread of global capitalism to places like China, India, and Eastern Europe is the main cause of the spike in energy prices. It’s a market signal that the new and prospering world economy needs more power. Consequently, this is not a recessionary supply crunch like we had in the 1970s. It’s a growth-oriented demand increase.

This is why the impact of high oil prices has been negligible, at least so far. Since the end of 2003, energy prices have more than doubled. But in annual terms the economy is growing by nearly 4 percent. Jobs are up and unemployment is down. Using the most accurate inflation gauges, the overall price level has increased only 2.5 percent yearly, and less than 2 percent excluding energy. Bond rates remain very low and stock indexes continue to appreciate.

Lumber prices, meanwhile, are plummeting, which suggests a cooling off of housing construction and home prices. Wall Street economist John Silvia believes condo markets are at the front edge of this cooling, with condo inventories rising, sale times lengthening, and prices softening. Private markets, city-by-city, are making their own adjustments based on affordability and the price of credit. There won’t a crash, but there will be a well-earned slowdown. That’s not to say the housing boom hasn’t been a good thing. Like the oil spike, it’s a big positive. The wealth-creating economic benefits of increased home ownership and the real-estate rebuilding of inner cities have been huge.

That leaves us with the age-old question of whether or not the central bank will over-tighten us into a recession. Fed policies have prevented oil inflation from spreading throughout the economy, but they should quit raising rates while they’re ahead.

Fed bankers and their fellow travelers have just gathered for an annual confab in Jackson Hole, Wyoming. It’s a scary thought. Like a tennis player grooving a bad backhand, mistaken monetary ideas often reappear in the foothills of the beautiful Grand Teton. Alan Greenspan, in his keynote speech, referred again and again to the importance of expectations about growth and recession, inflation and deflation. But instead of deferring to the wisdom of key market-price indicators -- like gold, broad commodity indexes, and bond rates -- he talks about complicated models of something called “risk management.”

Right now, stable commodities (excluding energy), low bond rates, and a steady dollar are signaling low inflation and moderate economic growth. But Greenspan’s neglect of the commodity-price-rule approach to policy makes one wonder if he is turning a blind eye to the message of the markets.

After all we have learned about the failure of central planning in the last century, are intelligent people today willing to accept the notion that government banks are smarter than markets? Or must the prudent investor worry that the Fed will overreact to home prices and energy costs by once again draining too much money out of the economy and smothering the growth effects of supply-side tax cuts? Are any of the Fed bigwigs in Jackson Hole watching the market price-rule indicators? Do they understand the teachings of Milton Friedman and Frederich Hayek -- that markets, which contain more information than economic models, are the best judges of economic “risk management”?

Respondents to a recent CNBC poll sizing up the leading candidates to succeed Greenspan next year chose “other” by a wide margin. This particular segment of the investor class is trying to signal the White House that a truly market-driven monetary policy is the surest way to preserve low-inflationary prosperity. Is the White House listening?