Oil-market frenzy and the Fed

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Economics, for good reason, has long been known as "the dismal science." But monetary policy, through which a nation's central bank seeks to adjust interest rates, has been anything but an exact science -- especially in recent years.

In the first place, central bankers exert far greater control over short-term interest rates compared to long-term rates, whose levels are determined in the bond market. Further complicating monetary policy are the variable time periods, or lags, during which the effects of interest-rate decisions reverberate throughout the economy. Meanwhile, pronounced domestic financial deregulation, which began about 25 years ago, brought with it constantly changing definitions of money. If the money supply could not be consistently defined, how could it be monitored or controlled?

In addition, as a result of the experience of soaring prices during the 1970s and early 1980s, inflation expectations play a much bigger role today than they did during the quiescent 1950s and 1960s. Finally, long-term interest rates were once primarily a function of domestic economic factors. Today, following years in which international financial markets have been increasingly integrated, global factors now play a major role in determining long-term rates.

For all these reasons, the job of the Federal Reserve has become far more complicated today. Contemporary commodity and financial markets, meanwhile, operate on hair triggers. And for good reason. Oil greases the world economy, but two-thirds of the planet's proven oil reserves are located in the geopolitically volatile Middle East. Throughout the past 30 years or so, that oil- and gas-rich region has been home to the simmering (when not boiling) Arab-Israeli conflict, the 1973 Arab oil embargo, the 1979 Iranian Revolution, the 1980-1988 Iran-Iraq War, the 1991 Persian Gulf War and the 2003 toppling of Saddam Hussein. Regarding financial markets, bondholders, whose portfolios were twice devastated within a decade (1973-1982) by two bouts of oil-induced inflationary spirals, are quite capable today of massively overreacting to the mere whiff of inflation.

So, given the recent fears of a terrorist attack in Saudi Arabia, whose potentially fragile royal family controls more than 25 percent of the world's proven oil reserves; given the escalating nuclear-proliferation worries about Iran, whose mullahs control another 10 percent of the world's oil and 15 percent of its natural gas; and given the ongoing insurgency in Iraq, where 11 percent of the world's oil is located -- is it any wonder that the price of benchmark crude oil leapfrogged from one nominal record to another last week, while the price of a summer contract for natural gas hit a record as well?

The price of West Texas Intermediate oil has now increased from less than $30 per barrel two summers ago to nearly $67 last week. That represents an average annual increase of roughly 50 percent during each of the last two years. It is worth recalling that a significant spike in the price of oil preceded each of the last five U.S. recessions, from 1973 through 2001. In an effort to mitigate these oil-induced inflationary pressures, it is clear that the 10 quarter-point increases in short-term interest rates implemented since last summer by Federal Reserve Chairman Alan Greenspan and his colleagues have been necessary. With oil and natural-gas prices continuing to soar, further pre-emptive action by the Fed is clearly needed.

Yes, the Fed's task is more complex today. That said, however, there still should be no dispute about which direction short-term rates need to follow. In fact, in today's frenzied oil market, the Fed should consider raising its targeted short-term interest rate by half a point. At 3.5 percent, that rate remains significantly below an appropriate level dictated by both historical and current circumstances.