Oil prices may give Fed dilemma

RISING oil prices will force the US Federal Reserve into a dilemma over interest rates if the current trend persists.

Ulster Bank Markets' economist Niall Dunne said that by linking Tuesday's 0.25% rate hike to oil prices, the Fed has unwittingly suggested that if oil prices go higher, it will put further interest rate increases on hold.

That, however, has implications for inflation and, by linking the slow down in the economy in the last quarter to the oil situation, the US Federal Reserve has created unnecessary uncertainty about its future interest rate policy, Mr Dunne said.

Without oil price pressure it is expected that the US will generate 4.5% growth in 2004. But on Tuesday when it raised interest rates, the Fed did not revise that figure or hint at a future revision.

Even if oil rises to $50 a barrel (the price hit a record €45 earlier this week) the belief is the US could still produce solid 3% growth for the year.

Where the dilemma arises is that higher oil prices not only mean slower economic growth, based on the Fed's comments this week, they also mean rising inflation.

For the markets down the line, it makes it that bit harder to judge how the Federal Reserve will react in the coming months if oil prices fail to soften, according to Mr Dunne. This is the classic between a rock and a hard place scenario, he said.

"If oil prices remain high, which looks inevitable, then monetary tightening might slow and America might fall victim to inflation," he said.

That also suggests a weaker dollar in the months ahead and, in overall terms, it leaves a certain cloud hanging over the American economic recovery.

Austin Hughes, chief economist at IIB Bank, believes the scenario is pretty clear.

The US will still raise rates by another 0.5% before the year is out, bringing the level of rates up to 2%, the current ECB rate.

However, Mr Hughes expected no rise from the ECB until December and then, he said, consumers can expect a steady rise in the trajectory across 2005.

Mr Hughes took comfort from the fact that the Fed did not in any way downgrade its economic view of 2004, which is for growth of 4.5% year-on-year.

On the oil price front, Mr Hughes said that unless the price goes over $50 per barrel for an indefinite period, the threat to the global economy will not be that great. It is, on the other hand, the most important factor determining how the US and the global economy will behave in the current year, he said.

Deep concern about disruption of oil supplies is a factor that will not disappear in the short term.

Closer to home, British interest rates may be nearing their peak, he said. Moderating inflation suggests one more hike of 0.25%, bringing rates to 5%, where Mr Hughes expects them to stay until early 2007 when slower growth will allow some easing.

From a global economic standpoint, Mr Hughes was encouraged by the absence of negative comment on the future outlook for the US economy by the Fed.