Oil Taketh Away, Oil Giveth
NYMEX crude oil has fallen to just $31 per barrel in the past month from above $38, having been above $60 within the past year. Global readings on the manufacturing economy have also been sinking, spreading concern over the possibilities of a marked slowdown in 2016.
Reacting to this set of circumstances won't be an easy or low-risk process for the Fed. The growing worry is that inflation expectations become unmoored, but rather than float away they just sink. Japan, which has battled deflation with little success for more than a decade, is an object lesson in the potentially very high costs of this.
Yet the U.S. consumer economy is finding low inflation of the cheap energy variety to be rather pleasant. Job growth is strong, auto sales continue to set records and there are some signs that wage growth may at last come through.
"How can the U.S. economy create 257,000 jobs when the dollar is strong and oil prices are low and HY energy spreads are widening?" economist Torsten Slok of Deutsche Bank wrote in a note to clients.
"Because the elephant in the room is the service sector, which benefits from lower oil prices. Bottom line: Don't interpret 10-year rates in the U.S. at 2.2 percent as a sign that the U.S. economy is unhealthy."
It is interesting to note that the European Central Bank, faced with a similar drop in market expectations for interest rates, expressed concern in the minutes of its December policy meeting about exactly how much information those prices contain.
The most likely outcome in the U.S. is that the market wins but victory is far from total. Having begun to raise rates, the Fed will want to carry through at least once or twice, though it is unlikely to hike four times in 2016. Instead we'll probably see a delay in hikes and a lower end point.
This will probably satisfy neither the stock nor bond markets, with inflation expectations perhaps falling along with risky securities. (