A Volatile Mix

Cheap money and expensive oil.

Wilmington NC – [Click the Listen button to hear Dennis' commentary.]

As every observer of economic events knows, the Federal Reserve has held short term interest rates at a 46-year low of 1 percent since last June. Recently, speculation has begun that interest rates will soon rise. Indeed, Fed chairman Alan Greenspan recently said that the Bank would no longer be ?patient? in raising rates. Of course, no one ? certainly not this commentator ? knows exactly what patient means.

The threat of higher interest rates stems from fear of inflation. This reflects the doctrine of too-much-money-chasing-too-few-goods. Low interest rates makes borrowed money cheap. When money is cheap, people spend more. This works well when the economy is in a slump. It increases demand, stimulating industrial production and higher employment. It has been an important factor in pulling the American economy out of its slump.

At some point, however, demand driven by cheap money may increase more rapidly than does output from factories, mines, wells and farms. Then, prices begin to rise. Inflation. Signs are appearing. The index of producer prices rose 0.7 percent in April. This was the largest increase in more than a year, and well above forecast.

To the surprise of no one, sharply higher prices for energy were a principle culprit. In April, gasoline prices rose 3.4 percent, and have continued upward ever since. Most consumers are now paying more than two dollars a gallon ? more than three in some areas. Crude oil prices reached a new 13-year high.

Booming world-wide demand has been a major cause of rising energy costs. While the US economic up-turn has prodded growth in world demand, China has had a greater impact. China has accounted for about a third of all world economic growth in the past 3 years. The rapidly-expanding Chinese industrial sector has been fueled by oil ? oil consumption increased 20 percent in the past year alone ? and by a ready supply of credit from that nation?s central bank.

In China, high world oil prices have combined with rapid economic growth to create pronounced inflationary pressures. The Chinese economy has grown at an annual rate of nearly 10 percent so far this year. Fixed investment in some sectors has soared by more than 150 percent. China?s inflation has reached a 7-year high.

Inflation has Chinese officials calling for economic restraint. Specifically, reining-in the growth of credit. This sounds a bit like Mr. Greenspan?s cautionary statement on US interest rates. But the banking situation in China is different. There, loans are rationed ? interest rates are less important in allocating credit, and in fact have not been raised in 9 years. The central bank ? the People?s Bank of China ? has now ordered a stop to new credit in a number of rapidly-growing industrial sectors.

Quite probably, Chinese officials hope that the Fed does raise US interest rates. This would give China room to raise their rates as well, further slowing the over-fired Chinese economy. If China unilaterally raises interest, funds would flow in from other countries, bidding up the value of the yuan, China?s currency. This would disrupt the yuan?s peg to the dollar. In turn, China?s competitive advantage in world markets would erode ? an advantage that has been built by maintaining a low-valued currency.

The longer the Fed waits, the more that inflation will pressure China to slow its economy. If Chinese officials more aggressively restrain credit, world oil prices could ease as their economy slows. This, in turn, might blunt some of the signs of inflation in the United States that are now threatening Mr. Greenspan?s patience.