Rising oil prices challenge Fed's inflation and growth strategy

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The Federal Reserve is grappling with the challenge of rising oil prices as it attempts to guide the economy towards a seldom-seen soft landing. The surge in energy costs, driven by supply cutbacks from Saudi Arabia and Russia, has seen oil prices jump nearly 30% since June, with U.S. crude surpassing $91 a barrel. This increase poses risks as the Fed aims to bring inflation back to its 2% target without sparking an economic downturn.

"The run-up in oil prices is at the very tip top of my worries at this point," said Mark Zandi, chief economist at Moody's (NYSE:MCO) Analytics. "Anything over $100 for any length of time and we're going to be very sick."

After raising interest rates by over five percentage points in the past 18 months, Fed Chair Jerome Powell and his colleagues are broadly expected to maintain them steady at their two-day meeting beginning today. However, supply shocks such as climbing oil prices present a conundrum for the Fed as they simultaneously fuel inflation and suppress economic growth. This leaves policymakers often unsure about whether to tighten or loosen credit in response.

This issue is becoming particularly pertinent now, as the central bank deliberates whether it should increase its benchmark rate once more this year before pausing for an extended period.

Traditionally, the Fed has tended to downplay the impact of higher oil prices on inflation, deeming the effect as temporary. This approach is one reason why officials concentrate on core inflation — which excludes volatile food and energy costs — when devising monetary strategy.

In August, consumer prices rose by 0.6%, marking the fastest monthly increase in over a year, with higher gasoline costs accounting for more than half of this rise. In contrast, core prices increased by 0.3%.

Despite these developments, some believe the Fed will look past this shock. Morgan Stanley (NYSE:MS)'s chief U.S. economist, Ellen Zentner, and her team suggested in a Sept. 13 note to clients that the drag on spending might even be seen as a welcome development, given growth has been stronger than the central bank had anticipated.

However, some Fed observers doubt the impact on inflation will ultimately prove so benign. "Energy costs are one of the big wild cards that the Fed is facing right now," said Lindsey Piegza, chief economist for Stifel Financial (NYSE:SF) Corp. "This could cause a significant reversal in headline inflation, forcing the Fed to take more aggressive action than I think investors are focusing on."

Meanwhile, the rise in oil prices adds to an increasing list of emerging headwinds to economic growth. Consumer balance sheets are showing early signs of strain as interest payments consume a larger share of expenditures. The excess savings households accumulated during the pandemic are likely to be depleted this quarter, according to researchers at the San Francisco Fed. A resumption of student loan payments in October will probably also dampen spending.

The trajectory of oil prices will largely depend on how high they go. Francisco Blanch, head of commodities research at Bank of America Corp (NYSE:BAC)., suggested on Sept. 12 that Saudi Arabia would become cautious about pushing prices up further once they exceed $100 a barrel, due to concerns about significantly reducing demand. But fine-tuning the market may not be simple. Even if Saudi Arabia and Russia ease their supply restrictions in early 2024, oil inventories will be critically depleted, leaving prices susceptible to shocks, according to a Sept. 13 report by the International Energy Agency.

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