Black Gold

By:  Dr. Charles Lieberman

Date:  8/11/2008

The dramatic decline in oil prices puts discretionary income back into consumer pockets, brightens the economic outlook, and relieves inflation concerns. We can only hope that the decline continues to replace fully the buying power lost as crude prices soared from less than $100 per barrel at the beginning of the year. The decline already in place also relieves the Fed's anxiety that the rise in commodity costs may worsen consumer inflation expectations, thereby forcing the Fed to hike interest rates when that would be counterproductive for economic recovery.

The Fed's decision to keep interest rates unchanged reflected its greater concern with weaker economic data that seemed more pressing than the worse news on inflation. More significantly, the Fed's language seemed to tilt more towards concern over recession than higher inflation, suggesting it is very unlikely the Fed will raise interest rates anytime this year, which remains our expectation. The Fed's priorities are in the right order, in our judgment. But the correctness of this decision was nicely supported by the ongoing plunge in crude oil prices, which will soon reverse some of the recent unfavorable inflation figures. More moderate CPI reports will be forthcoming over the next few months as a result and this is already reflected by yields on TIPs bonds, which already show a moderation in inflation expectations.

Lower oil prices can also reinvigorate consumer spending. Household spending rose 0.6% in June, a solid increase, but with prices rising 0.8%, real spending actually declined 0.2%. But if oil prices decline, income will be enhanced, helping boost household spending. This is invaluable, as consumer spending will be able to provide a boost to the soft economy as we wait for the housing market to stabilize.

In June, oil prices soared and equity prices collapsed in response. Now, equities are rebounding as oil prices have declined, which is appropriate. But evidence of stabilization in the real estate market is what's really required to establish a bottom for equities. Slowly but surely, evidence is accumulating that housing is close to bottom. Housing contract signings rose, inventories are declining and existing home sales have flattened. That represents major progress. Still, mortgage markets are not back to normal, which draws out the downturn and leaves the economic and market outlook uncertain. Thus, more progress is required. So the decline in oil prices will helpfully bridge the period until housing turns around.

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