Many forecasters are taking comfort in the decline in oil prices following the Sept. 11 attack. In the month since the attack, crude oil futures are down about US$5 to US$22.45. Driving prices lower is the idea is that decreased demand for oil with the world economy in a slump is offsetting any fear about the interruption in supply.
If I were a betting woman (and I am), I'd bet that oil prices are going up. If the Bush administration is serious about waging a war against terrorism, at some point the missiles are going to be aimed at the perpetrators of terrorism, including Iraq and Iran.
That should challenge the complacency about a guaranteed supply of cheap oil.
Now, higher oil prices are not inflationary per se. They only become inflationary if the Federal Reserve accommodates the increase. Since the central bank targets an overnight rate, supplying whatever reserves the banking system demands, a rise in oil prices will get accommodated unless the Fed decided to raise the overnight rate.
Judging by the explosion in the money supply, even before the Sept. 11 attack, the Fed is not about to deny anyone anything.
While the US$166 billion increase in the broad monetary aggregate M2 in the Sept. 17 week was "technical" -- the Fed provided adequate reserves to ensure the smooth functioning of the payments system since the disruption in transportation prevented checks from clearing -- M2 declined by only US$67 billion in the following week.
It is not fashionable right now to talk about inflation. At some point, however, all this money printing will come home to roost.
"It may not be fashionable, but inflation is going to be higher than it otherwise would," says Paul Kasriel, director of economic research at the Northern Trust Corp in Chicago. "War wrests resources from other uses." Even if the Fed had held the funds rate steady, the extra spending would have been accommodated, he says. "As it is, the Fed lowered rates so that other rate-sensitive borrowers will find it attractive to borrow more." Every war is different in the same way that every business cycle is different. Still, some things stay the same. Current monetary and fiscal policies may be disadvantageous in the long run. In the short run, it's hard to see why printing and spending won't perform their usual functions.
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