Fed's Interest Rate Decision Has to Include Stimulus from Falling Oil Prices

10/28/2014 10:29 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Falling oil prices create policy problems for the Fed, so MoneyShow’s Jim Jubak thinks it’s likely that the Fed will 'wait and see' on energy prices for a while before making a policy decision on interest rates.

What is the Federal Reserve going to do about falling oil prices? Lower oil prices are a huge stimulus to the US (and global) economy. So how do they get figured into the Fed’s decision Wednesday on ending the last $15 billion a month in asset purchases under QE3? And how do they get figured into Fed’s discussions of when to start raising interest rates?

At $80 a barrel, the global economy gets $1 trillion to $1.8 trillion in economic stimulus, CitiGroup calculates. Looking at just the United States, $80 a barrel oil is equivalent to a $600 tax credit for the average family with a car. (For context, the Economic Stimulus Act of 2008, signed by President George W. Bush in February 2008, provided a $300 per person ($600 for a couple filing jointly) tax credit in order to stimulate the US economy during the Global Financial Crisis.

In many ways this is a great problem to have. “Free” stimulus money? What could be bad? Especially because energy costs don’t get included in the core inflation measure so falling energy prices don’t increase the dangers of deflation.

But falling oil prices do still create policy problems for the Fed.

If oil prices are going lower—say the $74 a barrel forecast by Goldman Sachs—and will stay at those levels for a while, then can/should the Fed start raising interest rates earlier because the US economy is getting such a strong dose of stimulus from energy prices? That stimulus would, presumably, lead to stronger economic growth—say an extra 0.5% percentage point in annual growth—that would allow the Fed to normalize interest rates more quickly. (The Fed knows that the last crisis won’t be the last crisis ever and having some room to cut interest rates would be useful in that next crisis. Moving rates off 0% would give the Fed some breathing room.)

But if oil prices are due for a relatively quick rebound, then moving to increase interest rates sooner rather than later might wind up slowing the economy at the same moment when higher energy prices withdraw the current stimulus.

I think it’s likely that the Fed will wait and see on energy prices for a while before making a policy decision on interest rates that must take energy prices into account. At the moment, that 'wait and see' on energy prices isn’t likely to change the schedule for any first interest rate increase now pegged by the Wall Street consensus at mid-to-late 2015.

Especially because oil industry “experts” aren’t exactly on the same page. Two years ago, when oil prices were hitting an all time high, Leonardo Maugeri, former strategist at Italy’s ENI oil company, predicted that oil prices were headed for a fall in two or three years. His logic in 2012—which is what’s really interesting right now—is that oil companies, conventional and otherwise, were spending so much on exploration and development that growth in supply was almost guaranteed to outpace consumption. Oil companies have invested $2.5 trillion in the last four years, he points out, looking for and developing new supplies. Now Maugeri is forecasting that oil prices will fall to $75 a barrel (lower if markets panic).

Because big oil projects take years to go from search to production, much of the new supply discovered in that spending binge has yet to come on line. The current production rate of 95 million barrels a day could easily rise, he projects in a recent article The Oil Surprise: Why I was right, to 100 million barrels a day.

If Maugeri’s forecast is correct, then we’re looking at a long period when low and possibly lower energy prices add stimulus to the US and global economy. That’s certainly something the Fed has to consider.

On the other hand, Maugeri’s work isn’t without its challengers who argue that he has underestimated the depletion rate for conventional reserves (and has made questionable assumptions about the life of unconventional shale reserves); that he has overstated the ability of technology to extend the lives of oil fields; and that he has been too credulous in accepting oil industry estimates of proven and proved reserves.

Keep your eyes on the want ads to see if the Fed is hiring oil field geologists.

The central bank, it would seem, needs some good ones.

Related Articles on MARKETS