Policymakers now confront a global energy crunch
Since the outbreak of the coronavirus pandemic in early 2020, policymakers have had their hands full dealing with the fallout from global supply-chain shortages. More recently, they have confronted yet another challenge as global energy prices have surged to their highest levels in several years.
At the beginning of this week, the price for West Texas Intermediate (WTI) crude oil reached $82, its highest level since 2014. And Goldman Sachs is predicting further increases to $90 by the end of this year. Meanwhile, prices for natural gas, coal and electricity have climbed to record highs because of shortages in Asia, Europe and the United States.
So, what are the sources of these price pressures? And what, if anything, can policymakers do to alleviate them?
On the surface, the shortages bear some semblance to the early 1970s, when OPEC cut oil production during the Yom Kippur War, and food production globally was impacted by higher costs for fertilizer.
But the underlying forces today are more complex. They involve both the recovery from the COVID-19 pandemic that has boosted demand globally and energy policies in China and Europe that have curbed production of coal and other fossil fuels. J.P. Morgan researchers call it the “COVID-green” energy crisis.
In the United States, oil prices have rebounded from the lows near $20/barrel reached in the spring of 2020, when businesses were shuttered. And they are now above levels before the pandemic hit. One reason is OPEC cut production by 10 percent during the weak spell, and it has not restored it thus far. Another factor is shortages of liquified natural gas (LNG) abroad have caused businesses to switch to oil, which has added to price pressures.
Outside the United States, the problems are more severe, and governments are feeling pressure to respond.
In China, some provinces are rationing electricity due to a shortage of coal, which has curtailed industrial output. The shortage stems from the government’s efforts to control pollution and halt coal imports from Australia following that country’s agreement to develop a nuclear-powered submarine with the U.S. Press reports indicate the government is beginning to relax restrictions on coal production in some areas.
In Europe, the supply of natural gas has been affected by climatic conditions and green policies to reduce carbon emissions. Europe had an unusually cold winter and a lengthy calm spell over the North Sea during the summer that reduced output of electricity-generating wind turbines. According to energy expert Daniel Yergin, European governments are nervous about shortages continuing into winter, and they are scrambling to make subsidies available to households and commuters.
This situation has fueled tensions within the European Union (EU). Critics have blamed the price hikes on EU policies to combat climate change when there is a shortage of fossil fuels. EU climate chief Frans Timmermans counters that the transition away from fossil fuels will help to alleviate energy crises rather than exacerbate them. This debate is expected to continue at the European Commission’s COP26 Climate Change Conference in Glasgow in the first two weeks of November.
In the United States, investors are now focused on the effect higher energy prices will have on inflation. According to the Wall Street Journal, JPMorgan Chase economists believe they will boost inflation by 0.4 percentage points in coming months.
Thus far, U.S. bondholders have been remarkably patient as Consumer Price Index (CPI) inflation reached a 13-year high of 5.4 percent in September. Ten-year Treasury yields are about 1.5 percent, which means bond investors are willing to accept negative interest rates in real terms, presumably because they believe inflation is temporary.
But there are indications that central banks are reassessing their view. In a previous commentary, I noted that Federal Reserve Chairman Jerome Powell acknowledged that global supply chain disruptions in shipping and hauling have intensified and could keep inflation elevated for a while longer. The minutes for the September Federal Open Market Committee (FOMC) meeting confirm that Fed officials are worried and are escalating the tapering of bond purchases.
If oil prices also stay high, the Fed at some point will have to decide whether to raise interest rates. Its record over the past 50 years has been mixed. The Fed raised rates materially during the first two oil shocks in the 1970s when inflation was running at double digits. Thereafter, it did not tighten monetary policy when oil prices surged, because inflation was lower, and it viewed higher oil prices as a tax on consumers.
The most likely outcome this time is that the Fed will not react on the grounds that energy prices are volatile and beyond its control.
David McColl, an energy specialist at Fort Washington Investment Advisors, thinks this could be prudent. He believes financial markets for oil and natural gas have become disconnected from the physical markets. For example, McColl observes that markets for natural gas tend to correct to price spikes once storage levels are full at 90 percent, and they are relatively high today at 76 percent.
The main risk of not responding, however, is that gasoline and heating oil are major components of consumer spending, and they will likely impact consumer expectations of inflation. Indeed, the latest New York Federal Reserve survey taken in August showed that consumer inflation expectations reached 5.2 percent for the next 12 months and a median of 4 percent per annum for the next three years — the highest levels since 2013.
While monetary policy is on hold, the Biden administration is reviewing whether to tap into the U.S. Strategic Petroleum Reserve to curb increases in oil prices. No decisions have been taken so far, and the impact of doing so would likely be short-lived. Nonetheless, it could become an option if there are public protests about higher prices for gasoline and heating oil in coming months.
Meanwhile, President Biden has called on the oil industry to do what it can to alleviate rising gasoline prices. If all else fails, it may be time to pull out WIN (Whip Inflation Now) buttons from the Ford era.
Nicholas Sargen, Ph.D., is an economic consultant and is affiliated with the University of Virginia’s Darden School of Business. He is the author of “Investing in the Trump Era; How Economic Policies Impact Financial Markets.”
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