How do you do monetary policy when oil is hyperinflating?

Last week during the Federal Reserve’s (Fed) Semi-annual Monetary Policy Report to Congress, Fed Chair Pro Tempore (Chair in waiting) Jerome Powell confirmed his Fed was on track to raise interest rates next week.

If I was on another planet, I’d say better late than never.

But I’m on Earth and Russia just attacked Ukraine and will now begin to starve large parts of the world of food and energy.

And given the ripple effects I think we need to ask how much of the normalisation agenda will the Fed actually be able to get done - particularly if we’re talking $150+ oil, Russian oil bans, choked/unmet materials demand across the world, food shortages and broken supply chains for some time?

The answer is probably not as much as Jerome Powell would have you think.

It will be hard to normalise monetary policy in the U.S. (and elsewhere) if President Biden continues his woke anti-American produced oil and gas policy and decides to not reinstitute the U.S. crude oil export ban, and if Russia ambitions beyond Ukraine materialise and China sticks to its COVID-zero policy and faces energy and pork/food shortages.

Back to the 1970s if the world tries to go green?

If all of these things continue/occur, we could be looking at years to fix supply chains.

Conceivably, Russian and U.S. crude oil and natural gas could all come off the seaborne market. Under that scenario there would be oil, gas, fertiliser and food shortages causing hyperinflation for a time, until it hurts employment and becomes 1970s style stagflation.

I think everyone now pretty much agrees that the cost of going green means an increasing price of oil and gas during the transition, and an increase in the price of green metals.

This is the price of an underinvestment in new oil and gas projects as well as the impossibility of building, connecting and balancing sufficient renewable energy capacity around the world to take over from fossil fuels.

We also know that this transition will take many years to occur and cost somewhere in the vicinity of $150 trillion to reach net zero by 2030.

Therefore, if you underinvest in the incumbent energy source and you don't have enough new energy source, there's going to be a big hole for years not months.

I’m all for transitioning to a low carbon economy, but Biden’s policy whilst promoting world greening, appears to be a geo-political miscalculation.

New shale and conventional oil and gas projects have been killed. There’s been a ban on oil and gas leases on federal lands and waters since January 2021.

And as recently as last week new constraints on the Federal Energy Regulatory Commission (FERC) were introduced whereby FERC must now vouch that projects are in the public interest and won’t have a significant environmental impact, including greenhouse gas emissions.

Now the world waits to see if the U.S. bans Russian oil.

So, what happens to the green agenda when energy costs go parabolic?

There’s only one thing that can quickly fill that hole at volume, and that is more of the incumbent energy sources, but at significantly higher prices.

Oil, natural gas and LNG go up.

Biden will not want to see $150+ oil and watch Americans pay $6+ for a gallon of gasoline by the mid-terms in November.

He’s got a few months to get policy right and another few months for Americans to dodge the energy hyperinflation bullet, if that’s possible.

On the other hand he also wants to see the U.S. reindustrialise with a focus on renewables, as that was a major campaign platform and one of the reasons for his win.

Quite a conundrum.

Could he have both? That is, keep the green agenda (as long as it can be funded) and relieve energy prices, at home.

This might be achieved by: (a) reinstituting the ban on exporting U.S. crude; and (b) allowing energy companies to fire up the drill rigs.

That may not be terribly popular overseas because it would take both Russian and U.S. crude off the seaborne market.

But then again, Biden’s slogan was not to: “Build World Back Better”.

No one knows how this plays out.

And what does Jerome Powell say about $150+ oil in the context of monetary policy?

During the two plus hours of testimony at the recent Report to Congress (including a Q&A from the always theatrical John Kennedy from Louisiana) Powell answered a number of questions.

And in there were a few stats that Powell let slip which were revealing and give us some insight into what might occur to push the Fed off its normalisation path.

Specifically, Powell was asked what effect $150 to $175 per barrel of oil might have on inflation.

He answered that for every $10 increase in oil there’s something like 2/10ths of one percent of a rise in inflation – and a decrease of around 1/10ths of one percent in economic growth.

That means a drop of -0.3% in real growth, for every $10 a barrel increase in crude oil.

Some quick math shows that at $150 oil, add an additional percentage point of inflation and reduce growth by one half of one percentage point.

Given:

1. US Bureau of Labour’s annual inflation print for January was 7.5%; and

2. the Fed is predicting 4% nominal GDP growth this year, falling to a scarily low 2.2% in 2023 (but let’s use the 2022 number),

at $150 per barrel of oil (all other things being equal) inflation might be set to climb to 8.5% with U.S. economic growth falling to 3.5% (or more).

That would mean real growth of minus 5% (8.5-3.5).

Or call it a loss of around $1.2 trillion in U.S. GDP, which thought of another way would be like wiping out all of Australia’s GDP in one go.

In addition, and based on 2 year treasuries sitting at ~1.49%, it follows that at $150 per barrel of oil and inflation of 8.5%, real yields would fall to minus 7%.

Extrapolating from Powell’s estimates of what happens at $150 oil, we get to negative real yields (minus 7%) and negative real growth (minus 5%).

Those stats point to the potential for seriously negative growth and negative real rates at high oil prices (there’s a shock) and towards stagflation.

What he didn’t say was that if it plays out that way, market forces will do some of the Fed’s demand cooling work for it. But we shall see.

Biden’s playing a dangerous game of whack-a-mole by whacking oil and gas and he’s about to cop a drop kick where it hurts from his debt fuelled green agenda, if there is no compromise.

Where to now for the ‘careful’ Fed?

Russian oil bans, NATO country funding/supplying of Ukraine, the collateral damage with Germany stopping Nord Stream 2, and China’s stance on COVID as well as its recently announced shrinking target growth rate of 5.5% (the lowest in 30 years) all add to the uncertainty of what is going on.

Still, in light of all of this (other than for the China growth target which was announced later) Powell tells us there will be an initial rate hike of 0.25% in a couple of weeks and that going forward the Fed will be data dependent and “careful”.

He says that it’s too early to say if Russia/Ukraine will impact the Fed’s view on rates. But he did show some signs of smelling the war coffee. His view a month ago was that there was going to be a ‘series’ of rate hikes, but he said that right now uncertainty is elevated, so the Fed will “move carefully”.

Well, we can at least be thankful for good intentions.

While the Fed will almost certainly increase the federal funds rate on March 15-16, and although it’s reasonable to assume we will see even higher core prices particularly if the U.S. bans Russian oil, it’s possible that we may not see several additional rate rises this year if the slowdown in growth does some of Powell’s work for him.

Unfortunately, between now and that potential future state there will be some egregiously high prices. Also, there’s now more potential for fiscal stimulus (helicopter money) to help struggling families under the impacts of inflation/food shortages.

And given the U.S. is running a deficit, this will be borrowed, further adding to the debt load and dollar debasement.

Looking elsewhere for a moment, you’d have to think that it’s now almost a certainty that rates cannot go up in Europe. China has already made that decision. We’re sitting pat here in Australia and Japan just couldn’t do it.

Woke looks broke and gold looks good

If President Biden continues to pump out woke anti-domestic oil and gas production policies and waxes lyrical about his unfunded green energy transition which both play into Putin’s hands, he might cop one where it really hurts while he’s not watching.

And if that plays out and supply chains remain in disrepair, it might force central banks to stall normalisation plans, and governments might be forced to hand out more stimmies.

Where you have negative real yields and highly uncertain (or cratering) growth, plus imminent threats of war and inflation, there is no penalty to hold non yielding commodities like safe haven gold and globally transportable crypto, and other precious metals.

These should do well with gold already knocking on $2,000/oz. Sure copper, lithium, nickel and cobalt are doing well but that’s while growth remains. Gold does well when growth falters and is supercharged by war and inflation.

And in the financial asset department, bonds issued by commodity countries might also become valuable. This might make Australian bonds attractive once again, and hence we are seeing a strengthening in our commodity currency against the U.S. dollar (and others).

Here’s a wild card to leave you with - software based technology companies don’t like high interest rates, but they don’t care about the price of oil.

If the oil price does a lot of the work that Powell was looking to do, it might be that stable, profitable and low debt software companies perk up a little. Just a thought bubble at present.

Stay tuned for the upcoming Fed meeting on 15-16 March.

Mike