Interest rates and oil

[flaja]

I keep hearing that oil prices are up due to speculation. Investors are buying oil hoping that the price will go up in the future and by buying oil the investors themselves are driving up the cost of oil.

So what would happen if the FED were to raise interest rates? Historically, bank accounts (including CDs) have been safe investments. But when interest rates are low investors will put their money in the stock market or commodities markets or buy real estate so they can earn a larger return than they can get in bank interest. They will risk total loss for the sake of maybe earning higher gains.

So would raising interest rates take some of the money out of the oil market? I realize that raising interest rates on savings and investment accounts will encourage banks to raise the interest rates that they charge on loans, but would high loan rates be any better or worse for the economy than high oil prices are?

[James]

The Fed is faced with a dilemma as to whether inflation or recession is the greater threat to the economy. The Fed, through its primary tool of raising or lowering interest rates, can only tackle one problem at a time – either stimulate the economy by lowering rates or raise rates to fight inflation.

Stagflation fears vexing for Bernanke
Oil cost, inflationary pressure, weak economy harkens to '70s

By Rachel Beck | Associated Press
June 25, 2008

NEW YORK—Mark Twain once said, "History doesn't repeat itself, but it does rhyme." That's worth thinking about when comparing the current economy with the woes of the 1970s.

As they did three decades ago, surging oil prices are exacerbating inflationary pressures, further damaging a weak economy. The question is whether the toxic combination that produced stagflation then, crippling growth for years, is beginning to play out again...

Back then, the OPEC oil embargo sent crude prices soaring from $3.77 a barrel in May 1973 to above $12 by January 1974. Another price surge came later in the decade following the Iranian revolution, which pushed crude prices from around $14 a barrel in 1978 to above $30 two years later, according to Lehman Brothers.

As inflation rose over that decade to almost a 12 percent annualized rate—more than three times the annualized rate of 3.6 percent over the last four years, according to Citigroup—economic growth stunted and the dollar remained weak. Wage pressures also soared as workers demanded higher incomes to offset their higher costs.

But the Fed back then was lax in dealing with inflation, continuing to keep interest rates low to stimulate the economy even as prices accelerated.

It wasn't until Paul Volcker took the helm of the Fed in 1979 that the attack on inflation began. The supply of money and credit were tightened, and the central bank pushed short-term interest rates as high as 20 percent. The efforts worked, but the U.S. economy fell into a deep recession.

Source: Chicago Tribune

[flaja]

Originally Posted by James The Fed is faced with a dilemma as to whether inflation or recession is the greater threat to the economy. The Fed, through its primary tool of raising or lowering interest rates, can only tackle one problem at a time – either stimulate the economy by lowering rates or raise rates to fight inflation.

Supposedly you cannot have high prices and high unemployment at the same time, but the Carter Administration showed otherwise. In 1980 we had double-digit inflation rates on a monthly basis.

I don’t remember much of the OPEC oil embargo, but I was almost 13 years old when Carter left office; I never thought that I would see stagflation again in my lifetime.

As inflation rose over that decade to almost a 12 percent annualized rate—more than three times the annualized rate of 3.6 percent over the last four years, according to Citigroup—economic growth stunted and the dollar remained weak.

Except that the government does not calculate inflation now the way it did in the 1970s. For instance: If a computer with X memory sold for $1000 last year, but a computer with x+ memory sells for $1000 this year the government counts the price as a decrease when calculating inflation. The inflation rate in the 1970s didn’t take quality into consideration.

The last can of evaporated milk that I bought in 2007 was $0.58. When I bought the same size can last May it was $0.78 and when I bought it again just 3 weeks ago it was $0.88. But since food prices (as well as energy prices) are considered to be volatile, the government doesn’t factor them into the official inflation rate.

I’ve seen estimates for the real inflation rate from 7% to 12%.

But the Fed back then was lax in dealing with inflation, continuing to keep interest rates low to stimulate the economy even as prices accelerated.

Not really.

Image:Federal Funds Rate (effective).svg - Wikipedia, the free encyclopedia

In 1976 the Federal funds rate was about 5%. In 1981 it was around 19%.

http://research.stlouisfed.org/fred2/data/PRIME.txt

1970 began with the prime rate at 8.5%. It fell to 4.5% in February 1972. By the end of March 1972 the prime rate was 5%. It was 7.25% by the end of May 1973. It was 10% in April of 1974. It was back to 6.25% by the end of 1976, which was the lowest rate for the remainder of the decade. It was back to 10% in October 1978. It was 12% by the following August and then in October 1979 it was 14.5%. It peaked at 21.5% in December 1980.

The FED did not keep interest rates low for most of the 1970s (and the prime rate did not fall below 10% until 1985), it’s just that high interest rates in the 1970s did little to combat inflation- at least not in the short term.

[James]

The Fed did not react to inflation in the 1970s strongly enough. The real (inflation adjusted) interest rate was negative for most of the 1970s.

[flaja]

Originally Posted by James The Fed did not react to inflation in the 1970s strongly enough.

19% interest rates weren't strong enough?

The real (inflation adjusted) interest rate was negative for most of the 1970s.

Your documentation for this is what?


The main reason why inflation was so bad in the 1970s was political. The price of oil drove prices up across the board, but there was no shortage of oil during the 1970s. The first price spike came due to the OPEC embargo which was put in place because the U.S. supported Israel during the Yom Kippur War. The second spike came when the U.S. lost access to Iran’s oil supply following the fall of the Shah.

Furthermore, the inflation rate came down due mostly to Ronald Reagan’s tax cuts, not the FED’s interest rates. The money that was no longer going to pay taxes was invested in things like factories and machinery that allowed the economy to be more productive. The increase in the supply of goods and services lead to a decrease in prices.

[James]

Chart: US Real Short Rates History - 1953-2001
Chart: US Real Short Rates History - 1953-1979

Reagan's tax cuts, combined with a tight monetary policy and a decline in world oil and commodity prices helped to reduce inflation from 14.76 percent in March 1980 to 3.83% in December 1982.

Early in 1981, Weidenbaum [chairman of President Ronald Reagan's first Council of Economic Advisors from 1981-1982] issued the first written version of the president's economic plan, elaborating on what he would repeatedly call the "four pillars" of Reagan's economic program: tax cuts, spending cuts, regulatory reform and monetary restraint. Weidenbaum argued that these pillars were highly inter-related and that success hinged on the full implementation of each mechanism. Tax cuts were basic to achieving strong long-term economic growth; spending cuts would help offset inflationary consequences of the tax cuts; regulatory reform would increase the economy's efficiency and productivity while helping to curtail costs; and monetary restraint was fundamental to squeezing out rapidly escalating inflation. Source: Weidenbaum memoir offers inside look at rise of Reaganomics | Washington University in St. Louis

Reagan's 1981 Program for Economic Recovery had four major policy objectives: (1) reduce the growth of government spending, (2) reduce the marginal tax rates on income from both labor and capital, (3) reduce regulation, and (4) reduce inflation by controlling the growth of the money supply. These major policy changes, in turn, were expected to increase saving and investment, increase economic growth, balance the budget, restore healthy financial markets, and reduce inflation and interest rates. .. Monetary policy was somewhat erratic but, on net, quite successful. Reagan endorsed the reduction in money growth initiated by the Federal Reserve in late 1979, a policy that led to both the severe 1982 recession and a large reduction in inflation and interest rates. Source: William A. Niskanen. Reaganomics. The Concise Encyclopedia of Economics.

Bank Prime Loan Rate Changes: Historical Dates of Changes and Rates - compare 1970-78 to 1979-82.

[flaja]

Originally Posted by James Chart: US Real Short Rates History - 1953-2001 Chart: US Real Short Rates History - 1953-1979

Just how do T-Bills affect inflation? How does paying interest to an investor influence consumer prices? Buying a T-bill means that you are saving money, not spending it.

Reagan's tax cuts, combined with a tight monetary policy and a decline in world oil and commodity prices helped to reduce inflation from 14.76 percent in March 1980 to 3.83% in December 1982.

By today’s standards we had tight money policies for much of the 1970s. So why did the inflation rate still go through the roof?

Bank Prime Loan Rate Changes: Historical Dates of Changes and Rates - compare 1970-78 to 1979-82.

What is the comparison supposed to show? From 1970 to 1978 the lowest prime rate was 4.5% in February 1972. The highest prime rate was 12% in July 1974. This is 7 points over what the prime is now (as of last April). From 1970 through 1974 the yearly inflation rate (the average of the monthly inflation rates) ranged from a low of 3.72% in 1972 to a high of 11.03% in 1974 (reflecting the OPEC embargo). The average inflation rate for these years is 6.12%. But the prime rate for this same period was always higher than it is now (as of last April’s 5%). Compared to later rates, inflation from 1970 to 1972 was negligible, but interest rates were already heading up. Interest rates do not influence inflation the way they are assumed to. Low interest rates encourage investors to look for higher returns in riskier investments, i.e. investors speculate in the stock market, commodities market and real estate, and speculation is the surest way to have inflation.

[James]

Real 3-month T-Bill Yield is an indicator of real interest rates. The chart shows that the real (inflation adjusted) interest rate was low or negative for most of the 1970s. Negative real interest rates indicate a loose monetary policy. A tight monetary policy requires a high average real interest rate.

The general consensus is that monetary policy was not tight enough during the 1970s -

A substantial literature has developed that revisits the inflation experience of the 1970s in the United States and other countries.[1] This literature has advanced a variety of explanations for why macroeconomic outcomes were poor in this “Great Inflation” period compared to the period since around 1982, when inflation has been lower and more stable. Across all explanations, there is important common ground: monetary policy was, in retrospect, too expansionary in the 1970s, and a tighter monetary policy would have been required to produce lower growth in nominal aggregate demand and, hence, lower inflation. The differences in view lie in accounting for the background to this policy: in what macroeconomic objectives and models of the economy drove the policy decisions that actually took place. Source: Nelson, Edward, "The Great Inflation of the Seventies: What Really Happened?" (January 2004). FRB of St. Louis Working Paper No. 2004-001A Available at http://research.stlouisfed.org/wp/2004/2004-001.pdf

A variety of factors lie behind the inflation experience of the past three decades. During the rise in inflation from 1966-1980, two contributing factors were a strong economy and adverse supply shocks. The initial buildup in inflation in the late 1960s, for example, was demand driven and coincided with the Vietnam defense buildup. Similarly, the inflationary surge in the last 1970s occurred in an expanding economy. Supply shocks related to dramatic oil price increases in 1973 and 1979 also were important factors adding to inflationary pressures already in play. Unfortunately, monetary policy also played a contributing role in the inflationary process, as it most often does. Indeed, the general consensus is that monetary policy was too accommodative and too slow to respond to inflationary pressures during the late 1960s and the 1970s. For example, a declining real federal funds rate and rising money growth accompanied the increase in inflation in the late 1960s. Similarly, the inflationary increases of the late 1970s occurred in the context of a low real funds rate and strong money growth. Just as significantly, monetary policy also played a crucial role in containing and reducing inflation after 1980. The disinflationary process that began in 1980 started with a move to a restrictive policy stance taken by the Federal Reserve in October 1979. Moreover, I think that it is particularly important to note that, unlike earlier periods, we did not experience a renewed inflationary spiral as the economy recovered from the 1981-82 recession. I would attribute the success in preventing a rebound of inflationary pressures in the 1980s in some part to the Federal Reserve’s willingness to act in a more timely and pre-emptive manner to signs of inflationary pressures in 1983-84 and again in 1987-88. Indeed, even the low real funds rate in the early 1990s did not lead to higher inflation, in part, because the Federal Reserve responded promptly in 1994 and 1995 to signs that pressures were building to cause higher inflation. Admittedly, however, and in contrast to the 1970s, our objective of restoring price stability has been aided in recent years by favorable supply shocks in the form of lower energy prices and stronger productivity growth. Source: Hoenig, Thomas, M. [President Federal Reserve Bank of Kansas City] "Three Lessons for Monetary Policy" (April 22, 1998). Available at Discussions of monetary policy often take a very short-run perspective

The Great Inflation of the 1970s FABRICE COLLARD Universite de Toulouse I - CNRS (GREMAQ and IDEI); National Center for Scientific Research (CNRS) - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP) HARRIS DELLAS University of Bern - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR) -------------------------------------------------------------------------- April 2004 ECB Working Paper No. 336 Abstract: The two leading explanations for the poor inflation performance during the 1970s are policy opportunism (Barro and Gordon, 1982) and '' inadvertently'' bad monetary policy (Clarida, Gali and Gertler, 2000, Orphanides, 2003). In this paper we show that models of the latter category not only can account for high and persistent inflation but also have satisfactory overall performance. Moreover, both the Orphanides thesis (that loose monetary policy was the outcome of mis-perceptions about potential output rather than of inflation tolerance) and the Clarida, Gali and Gertler one (that weak policy reaction to expected inflation led to indeterminacies) are consistent with the data as long as there was a very large decrease in productivity at the time. Our result suggest that the assumption of policy opportunism does not seem essential for understanding the inflation experience of the 70s. Keywords: Inflation, imperfect information, learning, monetary policy rule, indeterminacy JEL Classification: E32, E52 Introduction During the 1970s, the inflation rate in the US reached its 20-th century peak, with levels exceeding 10%. The causes of this ''great'' inflation remain the subject of considerable academic debate. Broadly speaking, the proposed explanations fall into two categories. Those that claim that the high inflation was due to the lack of proper incentives on the part of policymakers who chose to accept (or even induce) high inflation in order to prevent a recession (the inflation bias suggested by Barro and Gordon, 1982; see also Ireland, 1999). And those that claim that it may have been the result of the honest mistakes of a well-meaning central bank. The latter category can be further subdivided into a group of explanations that emphasize either bad lack under significant imperfect information or bad luck together with technical, inadvertent errors in policy design. According to the latter view, the FED inadvertently committed a ''technical'' error by implementing an interest policy rule in which nominal interest rates were moved less than expected inflation (Clarida, Gali and Gertler, 2000). The resulting decrease in real interest rates fuelled inflation inducing instability (indeterminacy) in the economy and exaggerating inflation movements. The implication of this view is that adoption of the standard Henderson-McKibbin-Taylor (HMT) rule would have prevented the persistent surge in inflation. The bad luck under imperfect information view claims that loose monetary policy and inflation reflected an unavoidable mistake on the part of a monetary authority whose tolerance of inflation did not differ significantly from that commonly attributed to the authorities in the 80s and 90s. Orphanides (2003) has argued that the large decrease in actual output following the persistent downward shift in potential output was interpreted as a decrease in the output gap4. It led to expansionary monetary policy that exaggerated the inflationary impact of the decrease in potential output. Eventually and after a long delay, the FED realized that potential output growth was lower and adjusted policy to bring inflation down. Imperfect information about the substantial productivity slowdown rather than tolerance of inflation played the critical role in the inflation process. All these theories seem plausible. Identifying the most empirically relevant one has not been an easy task. A subset of the literature has tackled the issue of the contribution of policy to inflation directly, by examining whether monetary actions can be captured by a policy rule, and if yes, what the properties of such rule are. Relying on single equation estimation, Clarida, Gali and Gertler, 2000, claim that the FED indeed followed an interest rule during the 1970s but that rule contained a weak reaction to inflation that led to indeterminacies. Orphanides, 2001, disputes this claim. Using real time data, he documents the existence of a rule too, but he also finds no significant difference between pre and post Volcker tolerance regarding inflation. Lubic and Schforheide, 2003, estimate a small new Keynesian model (without learning, though, on the part of monetary authorities) and arrive at results similar to those of Clarida, Gertler and Gali's. According to their estimated model, post 1982 U.S. monetary policy is consistent with determinacy, whereas the pre-Volcker policy is not. Nelson and Nicolov, 2002, estimate a similar small scale model for the UK and find that both output gap mis-measurement and a weak policy response to inflation played an important role. And that the weak reaction to inflation does not seem to have encouraged multiple equilibria. A second subset of the literature again uses a small scale model but imposes --rather than estimates-- a policy rule. Lansing, 2001, finds that a specification with sufficiently large reaction to inflation is consistent with the patterns of inflation and output observed during the 1970s. Finally, a third subset of the empirical literature has investigated the events of the 70s within the context of calibrated, stochastic general equilibrium models. Christiano and Gust, 1999, argue that the new Keynesian model cannot replicate that experience, while a limited participation model with indeterminacy can (they do not address the role of imperfect information, though). Cukierman and Lippi, 2002, demonstrate how, within a backward looking version of the Keynesian model, imperfect information leads to serially correlated forecast errors and loose monetary policy. Bullard and Eusepi, 2003, argue that a persistent increase in inflation can obtain in the new Keynesian model even when policy responds strongly to inflation when the policymakers learn gradually about changes in trend productivity. Finally, in related work which however, looks at the disinflation of the 80s, Erceg and Levin, 2003, argue that the disinflation experience can be accounted for by a shift in the inflation target of the FED with the public only gradually learning about the policy regime switch. Our objective in this paper is twofold. First, to examine whether explanations based on rules -as opposed to discretion- are consistent with the macroeconomic performance of the 70s. We emphasize overall macroeconomic performance because we find attempts to validate particular theories based solely on the behavior of inflation too narrow. And second, to undertake a direct comparison of the two leading explanations from this group (Orphanides vs Clarida, Gali and Gertler). This is an important task, as the two explanations carry dramatically different implications for inflation scenaria in the future. If the Orphanides view is correct, then strong reaction to expected inflation is not sufficient to prevent bad inflation outcomes. The experience of the 70s can be repeated. If the Clarida, Gali and Gertler view is correct, then inflation is likely to remain tamed as long as the central bank reacts sufficiently strongly to expected inflation. We address these questions within the New Keynesian (NK) model. We ask whether and under what conditions the NK model with policy commitment can replicate the evolution of inflation following a severe, persistent slowdown in the rate of productivity growth. And if yes, whether the model also meets additional fitness criteria. We first examine whether the model can generate a ''great inflation'' under the assumption that the HMT policy rule pursued at the time did not differ from that commonly attributed to the ''Volcker-Greenspan'' FED (see Clarida, Gali and Gertler, 2000, Orphanides, 2001). We find that this is the case if the productivity slowdown is very large and there exists a high degree of imperfect information5. Imperfect information introduces stickiness in inflation forecasts, making the expected inflation ''gap''(the deviation of expected from target inflation) small. The underestimation of the inflation gap leads to weak policy reaction even when the inflation reaction coefficient is large. We also find that the overall macroeconomic performance of this model is good with two exceptions: The predicted recession is too severe. And the required shock is very large. We then examine the performance of the model under HMT rules that allow for indeterminacy (following Clarida, Gali and Gertler, CGG hereafter) due to a small reaction coefficient to inflation. Some of these rules have good properties: They generate inflation persistence and realistic overall macroeconomic volatility. Their main weakness, though, is that they also generate too severe of a recession. Our conclusion from these exercises is that the data support the view that the FED did not react to inflation developments in the 70s strongly enough, in the sense that it did not raise nominal interest rates sufficiently. Thus policy contributed to higher inflation. Nevertheless, this behavior may not have arisen from policy opportunism, an inappropriate policy rule would have sufficed. It is difficult, though, to identify the source of the weak reaction. Interestingly, our analysis also suggests that output stabilization motives may not have played as important a role in the great inflation as commonly assumed. The remaining of the paper is organized as follows. Section 1 presents the model. Section 2 discusses the calibration. Section 3 presents the main results. An appendix describes the mechanics of the solution to the model under imperfect information and learning based on the Kalman filter. Source: Collard, Fabrice and Dellas, Harris, "The Great Inflation of the 1970s" (April 2004). ECB Working Paper No. 336. Available at SSRN: SSRN-The Great Inflation of the 1970s by Fabrice Collard, Harris Dellas

[flaja]

Originally Posted by James Real 3-month T-Bill Yield is an indicator of real interest rates.

You don’t get it. T-bills do not have any influence on inflation. The T-bill market is a completely separate entity from the bank loan/mortgage market. If anything, an increase in the interest paid on T-bills indicates a scarcity of money, i.e., a deflationary period, since the government has to pay more to borrow money. If money is scarce (meaning deflation), there is less money that can be invested in T-bills so the cost of borrowing that money from investors goes up.

[James]

Interest rates and bond yields are highly correlated. The price paid for a bond is based upon the general level of interest rates at the time of purchase. When a security is issued, the coupon rate will be reflective of the current interest rate environment, and the price will typically be at or close to par (100% of face value).

Real T-Bill Yield is an indicator of real interest rates. The real interest rate (i.e. the nominal rate of interest adjusted for inflation) was low or negative for most of the 1970s and negative real interest rates indicate a loose monetary policy.

Across all explanations, there is important common ground: monetary policy was, in retrospect, too expansionary in the 1970s, and a tighter monetary policy would have been required to produce lower growth in nominal aggregate demand and, hence, lower inflation. Source: Nelson, Edward, "The Great Inflation of the Seventies: What Really Happened?" (January 2004). FRB of St. Louis Working Paper No. 2004-001A Available at http://research.stlouisfed.org/wp/2004/2004-001.pdf

...monetary policy also played a contributing role in the inflationary process, as it most often does. Indeed, the general consensus is that monetary policy was too accommodative and too slow to respond to inflationary pressures during the late 1960s and the 1970s. For example, a declining real federal funds rate and rising money growth accompanied the increase in inflation in the late 1960s. Similarly, the inflationary increases of the late 1970s occurred in the context of a low real funds rate and strong money growth. Source: Hoenig, Thomas, M. [President Federal Reserve Bank of Kansas City] "Three Lessons for Monetary Policy" (April 22, 1998). Available at Discussions of monetary policy often take a very short-run perspective