Questions for Vincent? If not, I’ll start.
I think the interesting question we have to answer is this: If Katrina had done the destruction that it did without affecting energy prices, how would we view it? We’ve had over the post-World War II period innumerable supply-side shocks. I remember the very prolonged steel strike of 1959, which had a profoundly debilitating effect on the economy overall, and that affected business confidence. When the strike was over, the economy came back with a surge. Theoretically, one can argue that the decline in economic activity as a consequence of a supply- side shock lowers wages, lowers compensation, and hence lowers expenditures. And one could theorize that a supply-side shock could bring on a recession.
I have never seen that happen. And I suspect the reason is that the underlying psychology associated with the replenishment that invariably follows a supply-side shock leads to expectations for the future that create forward momentum. I think this current situation is exactly that—a very large supply-side shock which, ex the energy price effect, in my judgment would have gone the way of all such scenarios: There would be a significant short-term retrenchment in activity, perhaps for a number of quarters. We would have the impact on the oil structure and on production and refining. But I submit to you that the price effect would not have been very high in earlier periods in our history when the crude price was $20 a barrel and when the excess supply in OPEC was several million barrels. In other words, we would have had the cutback in production at refineries and presumably in crude oil production, but the price effect would have been severely muted.
What is different today is something that has been mentioned several times around the table, namely, that the surplus has been depleted and, therefore, any little variation in supply hits the price. It’s not the crude price that is causing a problem, in my judgment. It’s the gasoline price. The higher price for gasoline does, of course, contract purchasing power. But more importantly, it has a very visual impact in that gasoline is one of the very few commodities— milk may be another one—consumers look at for which they have continuous price comparisons. So this particular surge has been very evident as we’ve watched consumer attitudes and consumer expenditures over the course of the gasoline price run-up and especially in the acceleration that occurred after August 29.
One fascinating thing about this is that we used to talk about the crude price as though it were a substitute for the gasoline price, and that is dramatically different this time. What we have found is that the best way of viewing the markup from crude prices to gasoline prices is to weight WTI 60 percent and the heavier crude, Maya, 40 percent. This traces the gasoline price reasonably well, with a relatively stable markup from the weighted crude price through the refining margin, through the marketing margin, and into the retail price.
What has happened since the big surge and the presumed shortfall in production is that the price for regular unleaded gasoline has gone up, as you know, to over $3 a gallon and the weighted crude price has gone up to $1.50 a gallon, which is the equivalent of about a $60 per barrel average weighted price. After accounting for taxes, this is a $1.10 spread per gallon. The fairly narrow, normal spread is 50 cents. So we have a 60 cent surge here, and it’s showing up partly in refinery margins, but in truly spectacular marketing margins. And it’s clear that this is utterly unsustainable because if there is an industry in this country that is highly competitive, it is the neighborhood service station. The people running those stations are looking at their competitors across the street and down the block, and they are continuously adjusting their prices.
So the question here is: What has happened? Well, what has happened is obviously refinery breakdown in two forms. One, we’ve clearly squeezed out any excess capacity in the United States. And two, in the process, we’ve had very considerable difficulty as well in refining the heavier crude oils. That gives us a worldwide mismatch between the type of crude oils we produce, which are more sour and heavier, and the growing needs for petroleum products that are increasingly for transportation, which of course include gasoline, diesel, and a lot of the lighter products. And essentially the production of those lighter products requires a very substantial transformation of the heavier crudes.
While we’re in better shape than Europe with respect to the balance of catalytic cracking and coking operations, we don’t have enough. As a consequence, we’re running into very severe pressures where the price margins are opening up considerably, especially for those refiners who have the capacity to refine heavier and heavily discounted crudes.
By the end of the year we’ll have the capacity back on line that, as Karen mentioned, is currently off line. It will gradually creep up. There is at this particular stage a very significant number of tankers moving in our direction that are loaded with motor gasoline produced in Europe, which under EPA regulations would not be able to be sold here. We import a little over a million barrels a day of gasoline, and a lot of it is reformulated basically into a form which meets EPA requirements but just barely. Having dropped the EPA requirements has opened up a substantial amount of the less stylized gasolines for the United States, and those products are going to hit our shores in a matter of weeks. In fact, that should start relatively soon.
So we should have those products shortly unless Rita turns out to be a really serious problem, and it may. But if you take a look at the probability distribution on the path of Rita, a goodly chunk of it is in northern Mexico and even east of New Orleans. They don’t need that, of course. It’s not as if they’ve missed the chaos and they need more of it. It will be a real mess.
But the point here is that the worst on the gasoline price is close to being over unless there is significant further damage to the refineries in the Houston area and below, which at this stage is conjectural. First of all, we’re making the assumption that the waters of the Gulf of Mexico are somewhat warmer and that, therefore, that can turn just a plain storm into a hurricane. Right now they’re talking a category 1, 2, or possibly 3 hurricane, but they’re guessing. They don’t really know; and the reason they’re guessing is that it’s not possible to know because there are too many variables. It reminds me a little of the Kenneth Arrow anecdote; it’s not quite the same but there’s a lot of that involved.
The markets are very sensitive. Having seen what happened with Katrina, they’re trying to discount—probably well over discount—the possibilities associated with Rita. As you know, prices have come down today; the last time I looked, the crude price was down over a dollar and gasoline was down 7 to 10 cents a gallon after a big run-up yesterday.
At some point reasonably soon we’re going to see gasoline prices move down. Ex Rita, they will go from over $3.00 a gallon at the pump down to probably $2.60. That is a very big move, and that will take out a significant amount of the consumer confidence erosion and conceivably the business confidence erosion—which I can see out there, and I think several of you have mentioned it—which, in turn, is a consequence of the erosion in consumer confidence. So I think that, short of the caveat of Rita, the scenario is not all that uncertain. There is no historical precedent to suggest that we can keep margins at the refining and marketing levels anywhere near where they are. We know why they are there; there was a supply-side shutdown. But the supply will be coming back, and indeed, imports from Europe are going to be quite substantial.
If that occurs, then clearly what we will have is a situation where the outlook is still very significantly restrained. Consumer outlays will be constrained because gasoline at $2.60 per gallon is not something that will galvanize a great deal of consumption. So, over the next number of months the economy will be fairly weak, but it’s going to be difficult to differentiate what part is the supply side and what part is not. As a consequence, there’s going to be considerable confusion and much, much less certainty than has been exhibited in financial markets over the last year or so.
So we’re going into a period where the one thing we can say for certain is that the level of uncertainty is going to be rising, and it’s going to be rising on two sides. It’s going to be rising presumably on the output side—and we’re going to be uncertain whether it’s related to supply or demand—and almost assuredly on the price side. The reason I say that is because we’ve been seeing a gradual upward creep in financial expectations, and none of us has experienced anything like this in 20 years. I guess I remember more of the pre-1980 period than most anyone around this table, and this has that very peculiar feel to it. It starts very slowly. It’s ambiguous. It’s disputable and unforecastable, but it grows and grows and grows. If you just look at the pattern, the change is usually too small in any short-term period to jolt you until you look back and say: “This has been growing for quite a while.” And then it starts to accelerate, largely because inflation expectations begin to erode. That’s what the history is. It’s very tough to forecast, but we have been through an exceptionally long period of disinflation, which has brought actual inflation expectations down and term premiums down. Everything is at its bottom. There is nowhere for them to go except up.
And one of the characteristics of these types of markets is that when things are going down there is an expectational variable that says they are going to go down further. In other words, the first difference matters. But when they get down as low as they are, the first difference goes to zero no matter what one can say about it because they can’t go any lower. And that starts to change the pattern.
I don’t know what the probabilities of this are. Anybody who makes a confident forecast of a turn like I’ve just been discussing is really reaching, and I am reaching. All I’m basically reaching to say is that I think the possibilities out there are a lot wider than we’re envisaging in the Greenbook. The fiscal situation in this country has gotten to be scary. There is nobody who wants to forgo a free lunch. There are big discussions about whether we ought to cut taxes or raise spending. There are very few who think in terms of whether we should worry about the deficit. Indeed, all one has to do is go out there and suggest, as I rather foolishly do on occasion, how Congress could curtail expenditures in a very reasonable way. Do you think everyone applauds? Not exactly.
We’ve lost our moorings. These budgets are out of control. The reason I say that is because ever since the surpluses—which did more damage to fiscal discipline than I could conceivably have believed—nobody finds any political purpose in showing restraint. That means inflation premiums are going to build into long-term interest rates at some point. I don’t know when, but it’s out there somewhere.
In any event, one of the things that we know with some reasonable certainty is that, unlike in previous periods, this sharp rise in prices is running into a degree of short-term elasticity, especially for gasoline, that I don’t think we were anticipating. Seasonally adjusted, weekly domestic demand for gasoline is off very sharply in recent weeks. Now, that’s not to say gasoline consumption necessarily is going down. It only means that primary shipments including imports are down 600,000 to 800,000 barrels a day. What may be happening is that gasoline stations are essentially running down their inventories—which incidentally are not small—and the tanks in motor vehicles that consume gasoline are being run down. The primary published data on gasoline inventories—that would mean at primary terminals—is 200 million barrels now. That has come down significantly.
On average, gasoline service station inventories are about 80 million barrels. Taking the average capacity of fuel tanks and figuring the probable level of gasoline in those tanks, that’s another 60 million. It’s conceivable that those numbers went down a great deal and hence the actual consumption of gasoline has not gone down anywhere near as much as the domestic demand. That strikes me as highly unlikely because if one is dealing with shortages, there is a tendency, if anything, for service stations to get more rather than less gasoline. It’s only in areas where there has been some form of rationing—even though they call it something else—that some stations have run out of gasoline.
But, in general, there’s very little question in my mind that we’ve run into something different—namely, a significant drop in gasoline consumption. That means that people are driving less, since the stock of cars hasn’t changed. Indeed, if you look at the overall unit use of energy, including oil, in the nonfinancial, non-energy corporate sector—as David mentioned— the actual per unit weighted amount of fuel per dollar of gross nonfinancial, non-energy corporate product has been going down fairly quickly. And I might add that a big chunk of it is in natural gas, which is natural gas demand destruction, not just conservation. So, the implied efficiency numbers are not as great as they have been. But one of the reasons why the profit margins have held up and the energy costs have not been pushed through just yet is that there is a significant amount of productivity going on, which means that oil has less of an effect than it used to.
So we’re not seeing great damage as yet to margins. Indeed, on a monthly basis we find that margins of nonfinancial, non-energy corporations—doing data calculations obviously quite roughly—flattened out from March to June. Now, it’s hard to know what was going on in July and August. There has to be some compression. I don’t see how it could be otherwise, but we don’t have any data on that.
Basically, I come down to the obvious question, which is of a twofold nature. If we choose to pause today, one obvious thing that is going to happen is that the federal funds futures curve, which now still gradually goes up even though it eventually flattens out, is going to flatten sharply. Then there’s the point that President Santomero made about the fact that the economy is going to be showing poor data over the next number of months. So, the statement that we are going to resume raising rates at some point soon is just not credible. The markets won’t believe it, and for very good reason—because the data, at least in the short run, are not going to give a rationale for raising rates largely because it’s not going to be clear what is the supply-side effect and what is the demand-side effect. That confusion is going to stay with us for a while.
So I agree that if we want to restore the path of further interest rate increases, it’s going to be next year, but it’s going to be next year in the face of what in my judgment is going to be a set of heightened inflationary forces. And if that is the case, we will be way behind the curve because what we are looking at for sure is less economic output and more inflation, though the precise combination is not easy to determine. But if you have a measure of stagflation about which we could say we had virtually none of it a year ago, we’re beginning to get some of it. We’re trading off increased nominal GDP for real GDP. And this sort of process is going to continue for a while.
I think that pausing at this stage is highly risky, but not so much because of the issue of our technical capability to come back to our path and explain why we’re raising rates. We could do it. We’re an independent agency. If we saw very poor data but saw inflationary forces, we could raise rates. I think we’d run into very serious explanatory problems, and I think at the end of the day we wouldn’t do it. I fear that we wouldn’t, even though we probably should.
The question, therefore, gets down not so much to the notion of perception and our ability to move, but to what is the right thing to do. And the right thing to do in my judgment is to recognize, as several of you have mentioned, that the real risk imbalance is on the inflation side. If it turns out that we raise the funds rate today—I don’t know what we’re going to do thereafter—and the economy actually shows a weakening beyond the supply-side or gasoline price-induced weakness, we have the capacity to move the rate back down sharply. For example, after 9/11, we opened up the faucets. On October 19, 1987, we just opened everything up. Nobody is going to complain if we suddenly reverse and start to pump money into the system, because the reasons for our doing that will be self-evident.
If, however, we pause here and the outcome I fear materializes, we could run into problems. I want to emphasize that I’m not pretending I know what the probabilities of that are. All I’m stipulating is that, on the basis of my experience, I sense that they are larger than we’re projecting, mainly because our projections are based on the experience of the last 20 years. And the period of the last 20 years has been the most extraordinary period of beneficence in economic policy that I can imagine, helped a good deal by globalization and the excess of intended saving over intended investment.
This period is going to end at some point. I think it’s just too risky to try to guess when that is going to be. And we ought to have a sufficient buffer out there when we start to run into some troubles because we don’t seem to be able in this country to have buffers on anything. For example, we allowed our excess electric capacity to run down in California, as it did a few years ago. We’ve allowed our oil refinery capacity to run down. I can name a number of other examples in non-energy related areas. But what we definitely need at this stage is a buffer in the monetary policy area to be sure we’re well positioned if it turns out that we’re running into the early stages of stagflation. If it turns out that is not the case, all to the better. We may have put in more insurance than was necessary, but that insurance, in my judgment, is very well worth the cost. So I would opt for a 25 basis point increase in the funds rate with the language in the statement essentially that of alternative B in its most recently revised form.
Comments? President Lacker.