The slide in oil leaves Fed with a slick dilemma

On the one hand, falling oil prices act as a big tax cut for consumers, potentially fuelling the recovery. But it could also wreak havoc on the Fed's plans to raise rates.

Just when the US economy appears to be gathering momentum, nudging investor attention to when interest rates will start to rise, the collapse in the price of oil poses a fresh headache for the US Federal Reserve as it considers its next move.

A halving in the price of oil -- including a 10 per cent dive this week to below $US50 a barrel -- brings a unique policy dilemma to the table.

On one hand, it acts as a big tax cut or income boost for consumers, thus potentially fuelling the recovery. On the other hand, the downward pressure on prices at a time when inflation is already unusually low means that raising rates too soon could spur deflation and trigger another downturn.

The slide could also dampen employment growth, as energy companies slash planned capital spending and dismiss workers. Analysts say oil has fallen below the break-even price for the vast majority of US shale oilfields, where many companies borrowed heavily to fund rapid expansion.

In the minutes of the Fed’s December policy meeting, the central bank leaned towards emphasising the positive impact of the price drop.

“Participants generally regarded the net effect of the recent decline in energy prices as likely to be positive for economic activity and employment,” the minutes said.

That sentiment should help to settle the worst fears in equity markets, where many investors interpreted the collapse in oil as an early signal of a renewed global economic downturn because of falling demand -- rather than the supply shock that is the single greatest cause as producers increase output.

Policymakers at the Federal Reserve signalled they were prepared to look through the disinflationary pressures of the energy slump, saying that inflation would gradually rise towards the 2 per cent target as the 'transitory' effects of lower energy prices dissipated.

That meeting was held on Dec. 16-17, and it could be that the further sharp declines of the past three weeks mean the downward price pressure will be less transitory than initially thought. This is a live concern for the euro zone, where prices fell 0.2 per cent in the year to December in the first negative reading since the depths of the global financial crisis.

The oil slump adds another layer of complexity to how the Federal Reserve will navigate its gradual exit from near-zero interest rates and will no doubt enliven the debate between hawks and doves at the next policy-setting meeting later this month about the timing of the first hike since 2006.

Former Fed Chairman Ben Bernanke, in a fascinating conversation with his friend and former governor of the Bank of England, Mervyn King, says most of time central bank policy meetings are rather dull. Except for those held in times of crisis. 

“The meetings themselves get lots of attention (but) most of them are deadly boring. They’re very scripted and the staff do all of the work,” Bernanke says.

Including the voting members of the Federal Open Market Committee, up to 70 staff and advisers from across the Fed system crowd into each policy gathering. The minutes are written in generalities that refer only to comments by “participants”, without naming names.

Bernanke, whom I first met at the Fed’s Jackson Hole conference in 2003 during his first year as a Fed governor, recalls how he had in a sense been prepared for the task of facing a massive financial crisis, having specialised during his academic life in a study of the Great Depression.

Both Bernanke and King were visiting professors at Massachusetts Institute of Technology in the 1980s, which laid a foundation for a long friendship and intense working association during the 2008-09 crisis.

He recalled the difficulty of explaining to the American public (and no doubt a large part of Congress) the counterfactual: what could have happened if the world’s central banks had not stepped in to coordinate the defence of the financial system after the collapse of Lehman Brothers in September 2008, which triggered a domino effect across Wall Street.

While the economic slump that became known in the US as the Great Recession did not turn into a depression, nor trigger the sort of financial panics that were commonplace in the 19th Century, critics argued that the actions of the Fed had produced nothing.

“It’s hard to explain to the electorate that things are pretty bad, but if we hadn’t done what we had done things would have been much worse. There’s plenty of evidence that when the financial system collapses, the rest of the economy collapses as well. By stabilising the financial system we avoided much, much worse consequences,” the former chairman says.

Bernanke’s successor, Janet Yellen, has been in the job for just on a year now and during that time has steadily removed the central bank’s stimulus to the economy via bond buying. In the year ahead, she will be confronted by diverging economic impulses that will create the Fed’s toughest challenge since the financial crisis.