Oil and Food Prices Keep Rising, but It's Not Time for the Fed To Act

Oil and Food Prices Keep Rising: Should the Fed Raise Interest Rates
Oil and Food Prices Keep Rising: Should the Fed Raise Interest Rates

With oil prices 14% higher in the last week, up $12 a barrel to around $97, consumers are poised to pay more at the pumps even as Libya's main oil company, Arabian Gulf Oil Co., resumes exports from rebel-controlled areas that account for a quarter of Libya's supply, according to The Wall Street Journal. Even though Libya accounts for a mere 0.5% of U.S. oil imports, those rising crude prices are percolating through the U.S. economy, leading many to wonder: Should the Fed change its course and raise interest rates to control prices?

Nobody likes higher prices, but the answer is still "no."

Raising interest rates has risks as well as benefits. One risk is that with the national debt at $14.1 trillion, more expensive debt service due to higher rates could crowd out other government spending -- thus cutting into economic growth. And higher rates would do little to lower those spiking prices because people will need food and oil regardless of how high interest rates get. And the Fed has limited ability to influence the global markets that set their prices.

The only reason the Fed would raise rates is if U.S. wages start to rise faster than its 2% inflation target. And with unit labor costs down 1.5% in the final quarter of 2010, median family income down 8.1% in the last decade and with 9% unemployment and 76% capacity utilization (below the 81% long-term average), there is no danger of workers getting together anytime soon to demand and get higher wages. So with the threat of higher labor costs quite low, the Fed will likely stand pat on rates until the unemployment rate drops closer to 5%.

Gold Bugs Always Want to Blame the Fed

As emotionally frustrating as it is for consumers to pay more for gasoline, food and clothing, those items account for a mere 25% of the typical household budget. But those prices are certainly going up -- partially because of higher oil prices. As I wrote in a DailyFinance article last week, higher oil prices affect every producer of goods that uses oil as a raw material -- such as plastics -- and any retailer that pays to transport goods or people, like airlines. With gasoline prices up 18 cents a gallon in the last month,that pain at the pump is real.

Some critics blame higher prices on the Fed's policies. As I experienced most recently during a CNBC sparring session last Thursday, the standard response of the gold bugs to food and energy inflation is that it's caused by the Fed debasing the dollar with low interest rates, out-of-control federal debt and record budget deficits. But Fed actions have little impact on commodity prices. Oil is traded on the global market, and worldwide supply and demand sets prices. It's worth pointing out that the global market tends to impose a growth tax of its own -- reducing U.S. GDP growth by 0.5% for every $10 increase in oil prices.

The one area where the Fed is contributing to the rise of oil prices is by making near-zero interest rate loans available to traders who are betting on fear: specifically, fear of more significant oil production cuts in the future.

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I wrote about this issue on DailyFinance's sister site, BloggingStocks, back in 2008 when oil hit a record $147 a barrel. At that time, the Commodities Futures Trading Commission found that traders who were borrowing money to buy oil futures and sell the dollar short accounted for 81% of trading volume. I wouldn't be surprised if such trading was a major factor in the recent oil price spike.

If the Fed were to raise rates now, there's little question that it would slow the nascent economic recovery. The U.S. has borrowed $14.1 trillion and higher interest rates would mean higher payments on that debt. Every dollar diverted to paying higher interest expenses is a dollar diverted away from more productive uses such as investments to boost the economy. The Fed will take that risk only if it believes inflationary expectations are taking hold in the minds of investors due to long-term wage increases.

Higher Pay for Workers Isn't Likely

With conservative state governments around the country opening up new fronts in the war against the American worker by moving to eliminate unions, there's no danger of U.S. wages rising in the foreseeable future. Instead, expect to see those bellowing elephants use their corporate-cash-filled trunks to break the unions, along with the hopes of workers for a reversal in the decade-long trend of lower pay and higher prices. (It's no coincidence that Koch Industries is a major contributor to Wisconsin Gov. Scott Walker, who is in the midst of a pitched battle to end collective bargaining for most state employees.)

Meanwhile, the Fed won't raise rates. Nor should it.