The Fed Can Cut Rates -- If Oil Cooperates

Oil prices have roughly tripled since the end of 1998. The U.S. has never experienced a price rise in oil of this magnitude without having a recession, yet personal consumption is still growing at an 8% rate and the consumer price index has only increased from 1.5% to 3.5% during this time.

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Price Gusher The price of West Texas Intermediate has roughly tripled since the end of 1998

Source: Federal Reserve Bank-St. Louis

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What's even more surprising is that the rise in energy costs hasn't led to a big rise in inflation expectations. The expected-inflation component of the University of Michigan's Consumer Survey continues to hover around 3%, and the break-even inflation rate needed to make owning inflation-protected Treasury bonds worthwhile is still 2.2% or less.

Part of the credit for keeping expectations in check has to go to the Fed's pre-emptive tightening that began last year. Without this tightening, it's possible that oil prices could have risen even more than they already have. The rise in oil prices could have also spread to other sectors of the economy, meaning that the Fed would have had to tighten much more than it did in this cycle. Bond investors are so confident that the Fed will not let inflation get out of hand that the whole investment-grade bond sector has had a powerful rally since the spring despite energy's climb.

The behavior of productivity is another reason for the relatively good inflation performance. As the unemployment rate fell from a peak of 7.8% in 1992 to its current 3.9% level, economists worried that wages would increase. As shown in the next chart, the growth rate of compensation per hour rose from 1.5% in 1993 to 5% by 1998. The gain in wages, though, didn't translate into higher inflation because productivity, measured as output per hour, pretty much kept pace during the second half of the 1990's.

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Inflation Beater Wages have increased, but so has productivity*

* Nonfinancial corporations. Source: Federal Reserve Bank- St. Louis

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Productivity is one of the hardest segments of our economy to measure, especially in the financial services arena. There is evidence that overall productivity totals are understated, so I've used the numbers for nonfinancial corporations. These figures are the ones preferred by Fed Chairman Alan Greenspan because, while they probably still understate productivity gains, they at least avoid the mismeasurement problems of financial companies.

The interplay between labor costs and productivity produces a series known as unit labor costs. This attempts to measure how much a company must pay its labor force to produce a unit of output. Productivity is now growing faster than compensation, so unit labor costs are actually falling.

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Cost-Effective Labor Productivity is growing faster than compensation, so unit labor costs are falling

Source: Federal Reserve Bank-St. Louis

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Unit labor costs are viewed as a measure of some of the cost pressures faced by companies, and so they are linked to inflation. The relationship between unit labor costs and inflation is one of the strongest and most enduring in economics.

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The Fed's Quandary While unit labor costs remain low, any rise in energy costs could turn into a nasty spiral

Source: Federal Reserve Bank-St. Louis

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While these two series often move in tandem, they have diverged since the end of 1998 when they were both growing at just over 1%. Unit labor costs have dropped to below zero since then, indicating that there is little pressure on inflation. Unfortunately, the GDP deflator has risen during this time, partly due to energy costs.

This dichotomy has put the Fed in a box. The economy has slowed in the past few months, and the low level of unit labor costs indicates that the Fed has room to ease, even if productivity growth was to slow. We are still a month away from the official start of winter, however, and, with refineries running at full capacity, the Fed remains worried that a further rise in energy costs could still turn into a nasty spiral.

The statement it released last week sent out a number of signals. The stock market reacted negatively to it, but most bond investors saw it as a step to a future ease if oil prices remain near current levels. Remember, the price of oil must keep going up in order to keep pushing up the consumer price index. If oil stays near $35 per barrel, it will eventually cease adding to overall inflation.

The statement also allowed the Fed to get feedback from the bond market. If bond investors did not feel comfortable with the prospect of an easier Fed, long-term rates could rise and more than offset the Fed's action. This could be troublesome for the high-grade market, and disastrous for the junk market. Since the bond market gave a vote of confidence to the Fed's strategy by rallying on the release of the statement, the chances of a future ease have increased.

So, we go back to watching the oil markets for the next clue. If oil holds the line here, I'd expect both short and long rates to head down.

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Brian Reynolds is a certified financial analyst with more than 16 years experience as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at Brian Reynolds .