The world economy is on the threshold of a change in its interest rate cycle. The first such change, in the United States, reflects a need to normalize interest rates at an ideal level of between 4% and 4.5%. Currently, the price of money in the U.S. is 1%, a historic low. It seems that the U.S. will emerge without damage to its economy. However, just when things are turning around and authorities are moving “patiently” from a lax monetary policy toward “measured” restrictions, the worst possible enemy for the world’s largest energy consumer [the U.S.] has reappeared — rising petroleum prices.
“The history of [energy] shocks demonstrates that petroleum [price rises] can lead not only to a sudden change in the movement of rates, but in the very fundamentals of economic conditions,” says Juan Antonio Maroto, professor of finance at the Complutense University of Madrid. As history demonstrates, when prices rise sharply, petroleum threatens stability. Prices for a barrel of Brent and West Texas Intermediate crude, used respectively as benchmarks for Europe and the United States, have reached levels not seen since October 1990. That was shortly after Iraq invaded Kuwait in what turned out to be the prologue to the [first] Persian Gulf War.
During the first four months of 2004, the average price of both crude oil benchmarks was at their highest levels in more than two decades. The current price of petroleum is the highest since the beginning of the 1980s, shortly after the great oil crisis that occurred during the Islamic Revolution in Iran. Today’s record-high prices take place in a context of global economic recovery and consumer [spending] growth, led by the U.S. and Japan. Europe is still stagnant, a stumbling block.
A major reason for this situation is uncertainty generated by recent [terrorist] attacks in Saudi Arabia, the world’s largest producer of petroleum. This uncertainty has contributed to growing fears about world supply, augmented by problems in three major producers during the past year: The strike in Venezuela; ethnic disturbances in Nigeria, and the war in Iraq. The strong growth in American consumption has led to even more uncertainty about the supply of gasoline, which is at record-high prices on both sides of the Atlantic.
Meanwhile, the Organization of Petroleum Exporting Countries (OPEC) has cut its official production levels twice since October, although OPEC nations are unofficially pumping more crude into the market than specified by official quotas. The cartel could review its restrictive approach to supply, starting in June. According to Rafael Pampillón, professor of economics at the Instituto de Empresa business school (Madrid), “There are major uncertainties on both sides [supply-demand] of the petroleum balance. Regarding supply, there are the OPEC restrictions, and violence in the Middle East. On the demand side, there is greater demand from China. Moreover, the recovery of the United States has led to increased consumption.”
The upswing in prices for crude oil and gasoline threatens to create imbalances during the transitional period for interest rates. It generates inflationary tensions that could force the Federal Reserve to protect price stability by raising rates and removing liquidity from the market. “Over the last 25 years, the fundamental goal behind raising rates was to reduce inflation,” explains a report by the management board of Schroders Investments funds. Nevertheless, experts at the British firm warn that the current change of cycle is different from previous cycles, in that inflation is currently viewed as low. “From this perspective, higher interest rates can be seen as a signal that authorities are showing their confidence in the economic recovery,” adds the same report.
How quickly debt becomes more expensive will depend in large measure on economic developments in coming months. The high price of petroleum is a source of great concern to monetary authorities. It could act as a brake on economic growth because it has a predictable impact on consumer price trends. For example, the average price of crude oil in April 2004 is more than 40% higher than during the same month last year. This alarming price differential could trigger inflationary pressures in developed economies that had recently enjoyed a certain equilibrium in their prices.
This equilibrium is delicate, says Maroto. “The U.S. cannot raise rates without damaging the recovery, and the European Union cannot lower them in order to avoid inducing a higher inflation rate. It is hard to say how long this delicate balance will last. However, if crude oil prices continue to rise, the balance will likely change, starting in September.” Maroto sees several scenarios for higher prices. “During this period, inflationary components will have made their way into American prices. Or, the modest expectations of European recovery will have been damaged and, along with them, expectations that the euro will persist as a strong currency.”
Why Europe Is Worried
Europe’s euro-zone nations will also come under price pressures fed by the energy sector – but without benefit of the rising euro, which acted like a protective cushion. “The rising price of petroleum will have an equal impact on inflation in both Europe and the United States,” says Oriol Amat, professor of economics and business at the Pompeu Fabra University. The U.S. dollar is the currency in which crude oil is bought and sold. The euro’s strength versus the dollar has meant that the price of a barrel of crude rose only 27% in euro terms from April 2003 to April 2004. Meanwhile, the U.S. economy suffered a 40% rise in crude prices [in dollar terms.]
The tables could now be turning. Encouraged by strong data about the U.S. economy, and expectations that interest rates will rise, the greenback has reclaimed its throne as the world’s strongest currency. This has magnified the impact of the rise in petroleum prices elsewhere around the world. Since January, almost every foreign currency has fallen significantly, relative to the U.S. dollar. The Japanese yen has dropped by 5.35%; the euro, by 6.1%; the Swiss franc, by 5%. Meanwhile, the Australian and New Zealand dollars have also dropped [relative to the U.S. dollar] by 6.93% and 7.4%, respectively. Pampillón adds, “Until now, the European Union has used the euro to side-step the impact of the high price of petroleum, because crude has been cheaper in terms of the European currency. But the EU is now beginning to feel the pressure, to the degree that the euro is also beginning to depreciate.”
Will Latin AmericaBe a Victim Again?
Latin America views the new situation with apprehension. “It seems obvious that [Latin America] will wind up being hurt,” says Maroto. “The more rapidly and abruptly changes in interest rates take place, the more [Latin America] suffers.” In 1994, the rapid rise in interest rates dealt a severe blow to emerging economies, including Latin America. U.S. bonds behave as a benchmark for issuing banks in these countries, both private and public, because debt is usually denominated in dollars. “Given the higher debt of emerging markets, the Brazilian economy can be one of the most affected by the change in American interest rates,” says Paulo Vieira da Cunha, chief economist of HSBC for Latin America. Brazil has a foreign debt obligation amounting to $221 billion, and $35 billion in short-term obligations. Nevertheless, Vieira da Cunha is cautiously optimistic about the Brazilian situation. “Brazil continues to be vulnerable from a fiscal and external point of view, but it is less vulnerable than before, especially in foreign markets.”
When the cost of foreign-currency debt rises, Brazilian debt becomes less attractive to foreign capital. This trend would be magnified by a rise in the profitability of U.S. fixed-income instruments. Countries such as Brazil and Mexico, which are very dependent on flows of foreign capital, could suffer damage to their foreign capital inflows. However, experts are not convinced that the situation will become as acute as it was a decade ago. “First of all, in 1994, no one expected rates to rise. Second, the structural situation of Latin American markets is much healthier now than at that time. In every country, inflation rates are much lower and foreign-currency debt is significantly lower, and it is much longer-term,” Elena Eyries told Expansión, the Spanish business daily. Eyries manages a Santander Central Hispano Gestión fund that invests in Latin America.
How Will Change Be Managed?
It is almost as important to manage the process of returning to normal rate levels as it is to manage a decline in rates effectively. The economy may not be able to digest a rapid rise in prices. The markets remember what happened ten years ago when rates rose from 3% to 6% in barely twelve months. “In terms of a cycle of benefits, we are more or less where we were in 1994,” says John Veils, an analyst at HSBC, the British bank. Experts agree that the current situation is different. Above all, “markets are not going to be taken by surprise now,” a memo from Barclays Capital says. However, the knowledge and experience of Alan Greenspan, who heads the Fed, could give way to uncertainty, due to his possible retirement or because of upcoming U.S. presidential elections. Some experts believe that the elections could delay the process of introducing the anticipated, restrictive monetary policy.
Greenspan, chairman of the Federal Reserve Board, is nearly 80, and he will finish his fourth term at the helm of the institution on June 20. The macroeconomic outlook is encouraging, but there are clearly troubling clouds on the horizon. Greenspan’s possible retirement is one of those clouds. “His re-nomination as president [of the Fed] is almost certain for this year. In all likelihood, he will remain on the Fed’s board, but not as chairman, until his mandate as governor ends in February 2006,” says João Gomes, professor of finance at the Wharton Business School. Investors have confidence in Greenspan because he presided over the longest period of growth in American history. He knew how to combat the onset of recession in 2001, and how to manage the period of uncertainty after ‘9/11.’
Greenspan has demonstrated his responsiveness. As head of the Federal Open Market Committee (FOMC), the Fed organ that dictates monetary decisions, Greenspan opened the spigot of liquidity. The Fed put into place 13 interest rate cuts between January 2001 and June 2003. In the course of two and a half years of monetary relaxation, the official price of money moved down from 6.5% to 1%, the lowest level since July 1958. This process, which made money so much cheaper, played a fundamental role in the recovery of the American economy. The GDP has grown at an average rate of 4.9% over the four last quarters.
With economic recovery underway, petroleum emerges as a threat that could impose a shock on the next upward cycle in the price of money in the U.S. Gomes says that only a major economic event could prevent a rise in interest rates. “Rates will probably rise more rapidly until they reach a more neutral rate of close to 4% or 5% in the next two years. We could see rates reach nearly 6%, as in 1994, but only if the economy doesn’t show signs of slowing down and/or if inflation begins to rise perceptibly.” The fate of the recovery is now in the hands of the price of money.