Lower Energy Prices Could Be Inflationary
I read a short article Friday morning about when the Federal Reserve might increase interest rates. One money manager interviewed argued that the drop in oil prices means that the Fed will raise rates later than initially thought. This argument is based on the notion that lower oil prices are deflationary and that the Fed won’t raise rates until it sees evidence of inflation.
This kind of thinking makes sense on the surface, but it could be off base. When oil prices were rising, the Fed and a number of economists said we should ignore headline inflation and focus instead on core inflation. For those who don’t know, core inflation is the rate of inflation if you exclude food and energy. The reason economists study core inflation is because food and energy prices are notoriously volatile. As a result, it makes sense to examine both core and headline inflation.
However, if the Fed focuses only on core inflation when energy prices are falling, it could miss inflation in other kinds of goods and services. While the Fed will monitor both inflation figures, it will likely pay more attention to headline inflation in a falling energy price environment. The Fed does not want to fall behind the curve.
Furthermore, lower energy prices could actually be inflationary rather than deflationary. This is because lower energy prices should generate more economic activity. Demand for all kinds of goods and services could rise when energy prices are low. As a result, businesses are more likely to expand and hire more people. This increased economic activity caused by lower energy prices could produce higher, rather than lower, headline inflation. That alone could prompt the Fed to stick to its plan to raise rates. At this point I continue to expect the Fed to increase the fed funds rates during the first half of this year.
Read Vahan’s blog at Janjig.com.