Oil, money and benign neglect

James Robinson argues that raising US interest rates would be an inappropriate response to the increase in energy prices Published: November 28 2000 20:37GMT | Last Updated: November 28 2000 20:40GMT

The steep rise in energy prices has created an expectation in some quarters that interest rates will be raised, possibly quite soon, in the US and Europe. This belief, whether or not it turns out to be correct, represents outdated thinking. More important, it poses a serious and unnecessary threat to the longest economic boom on record - a boom that could go on for years if central bankers do not bring it to an end.

By raising interest rates - or even by simply voicing the possibility of higher rates - the US Federal Reserve and other central banks risk fostering the cost-push inflation that they seek to neutralise.

Comparisons with the 1970s are misleading. Then, when oil prices rose by a factor of three, inflation took off in the industrialised economies. This time, however, the price shock is unlikely to have a similar effect. Although some pressures are beginning to be felt, there has been no discernible change in US inflation. And while the rate of inflation is up about 1 percentage point in Japan and Europe, the impact of higher energy costs can hardly be compared with previous bouts of price collusion by oil-exporting countries.

True, it is too early to judge the full inflationary effect of the oil price shock. But it is already clear that, compared with the 1970s, global competition is much stronger and the responsiveness of aggregate supply is much quicker. The growth of productivity in the internet age is also a powerful and completely new factor. Against competitive forces of such magnitude, few businesses have sufficient market power to be able to raise prices.

Moreover, technology has enabled great expansions in the growth of productivity. This raises output while neutralising the inflationary effects of cost factors such as the growth of wages. Companies are using the internet to streamline business processes, driving operating costs down. Information tools are being used to yield greater productivity, control inventories, gather point of sale information faster and build efficient business processes to integrate suppliers, customers and employees.

Simply stated, competition is the most effective anti-inflation weapon there is on the demand side and technology allows real income to grow without unleashing inflation. Taken together, competition and technology allow faster adjustment to external economic shocks. In this new environment, there is little chance of a shortage of supply, except for occasional bottlenecks.

What role should central bankers play in managing monetary policy? Clearly, there is a significant role in the field of supervision within the ever expanding financial services arena. Systemic risk must be closely monitored and effective working relationships among central bankers and regulators must be maintained to ensure depth and breadth of all money and capital markets, as well as sensible, responsive regulations and oversight.

But monetary policy itself should be left on autopilot unless there are substantive changes in the environment. Contrary to conventional wisdom, there is no need to raise interest rates to choke off "potential" inflationary risks unless the price pressures being addressed are truly demand-led. Watchful benign neglect is the order of the day.

Policy-makers around the world should be directing their energies towards creating the right conditions for enhanced competition and setting policies that help companies assimilate new technologies faster than at present.

This is especially true now that "excessive exuberance" is no longer present in the equity markets. Indeed, sentiment may have swung too far in the other direction. The Fed's interest rate rises to date - combined with the expectation of higher rates to come - have done what they always do: bring asset values down, particularly in the technology sector.

It is ironic that the Fed's actions have raised the cost of capital substantially - if not eliminated access to capital entirely - for the very companies that were leading the charge to bring aggressive competition to the marketplace. Should the Fed not be as concerned about the funding squeeze on small, innovative companies as it is on the implications of tight labour markets?

Inflation today is far less threatening than the prospect of recession or slow growth. Rather than raising interest rates, central bankers should be planning to offset the adverse oil price shock with a concerted round of interest rate cuts. As the country best placed to benefit from greater competitiveness and new technology, the US should lead the charge.

Money, like oil, is a commodity. Raising the price of money can cause the price of goods and services to go up, triggering inflation. Apart from monopolistic producers such as the Organisation of Petroleum-Edporting Countries, one of the few institutions with the power to raise prices today are central banks.

James D Robinson III is co-founder and general partner of RRE Ventures and former chief executive of American Express

http://markets.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3H33A04GC&live=true

-- Martin Thompson (mthom1927@aol.com), November 29, 2000

Answers

OK, I know I don't have much economic sense. But if competition is so hot right now that "few businesses have sufficient market power to be able to raise prices," what are those businesses to do when their own costs (heating oil for the office, anyone, or do we just ask all employees to wear long johns and stocking caps on the job? Fuel for company vehicles? Stuff like that?) go up? Seems to me, if they can't raise prices because they'll be undercut and driven out of business, then they'll go out of business 'cos they're losing money (or losing employees to offices that can/will afford to heat them? :-) ). Either way, wouldn't there be a falloff of businesses -- and then there is less competition, so the surviving companies *do* have breathing space to raise prices?

Seems like *something's* gotta give.

-- l. hunter cassells (mellyrn@nist.gov), November 29, 2000.