Just before Hurricane Katrina struck a glancing category 1 blow at south Florida and then roared through the Gulf of Mexico to devastate Louisiana and Mississippi as a monstrous category 4 Hurricane, oil prices touched $70 a barrel and the Fed continued to nudge rates higher.
In the context of the terrible physical destruction and human tragedy along the Gulf coast, talking about economics pales in importance. But oil prices, interest rates, and economic activity in general will have a real impact on the recovery of the people most affected in this natural disaster, and that makes what Kathleen Camilli, president of Camilli Economics in New York, had to say just before this event even more poignant.
In your Camilli Economic Insights report you wrote about how consumers are being affected by oil at $67 a barrel and higher, and that you felt that the Fed Funds rate of 3.5% is high enough for now. Why? I'm mostly worried that higher oil prices will eventually start to crimp economic activity. I'm much less concerned than the Fed about the potential inflationary impact and more concerned about the negative economic impact at this level of oil prices. What caused me to write that article is that Wal-Mart has sounded this siren that at this level of oil prices their lower-income consumers are starting to be affected. The threshold may not have been at $40 or $50, but certainly at close to $70, it now is a concern.
And $70 has been a number that people have quoted for quite a while, right? I think there's tremendous uncertainty within the economics community about what level is important. There was apparently a report that came out of Goldman Sachs that said nothing will happen until [oil] goes to $80 to $100 and then it will stay there for five years, so I don't think there's been much agreement at all about what level would have a dampening impact. Some people with a standard econometric model thought that a much lower level of oil prices would have an impact and the reason I say that [there is uncertainty] is not only because of them, but the consensus forecast in the economics community in the beginning of this year was that growth would slow to 3.6% because of oil, and that has been wrong.
Do you feel that if rates continue to go higher, even to a 6% Fed Funds level, that's where we might get a squeeze? I don't think Fed Funds should go much beyond the current level, 3.5%. I participate in the Blue Chip Forecasts, which are done monthly, and I just reluctantly, begrudgingly, forecast another quarter-point increase, to 3.75%. But I really think the Fed should pause here because of the uncertainty regarding the potential negative implications for the economy that are already in the pipeline.
Can you detail those? Some lower-income consumers are already being affected by higher oil prices and it's causing a substitution effect in their family budget where--because they need to consume energy, whether it's for transportation or for heating or for air conditioning--they need to substitute out something else in order to pay for that higher cost of energy.
It trickles through? Yes. If the Fed keeps tightening here--as some economists have suggested, "The Fed needs to raise the Federal Funds rate to 4% or 5% or higher because of the inflationary effect of oil"--what I'm saying is no, they need to stop here, and pause to see what the negative ramifications on growth might be from higher oil prices, and not be so concerned about inflation because we've already seen that oil is not having much impact on broad inflation indexes. It might be having an impact on certain select family budgets, but it's having very little impact on the broader inflationary indexes because you have dampening inflationary impacts like the impact of China and India on worldwide traded goods.
Prices of goods staying lower? Exactly. For example, prices at Wal-Mart have not gone up because of higher oil prices. Why? Because Wal-Mart is a big company that outsources and makes plentiful supplies of cheap goods available. Also, it's a company that even though it suffers with the higher transportation costs, it can offset [those costs] somewhere else on its balance sheet, or they can hedge forward. When you're a big enough company you can do things like that. It's really the smaller stores that can't do those sophisticated things, that suffer more, and we as consumers suffer more in local areas where there is no price competition or no outlet for passing on the higher energy cost--and the higher energy cost is passed directly on in the price of the local services that you're buying.
What should advisors do to help their clients hedge their portfolios and get ready for this scenario? The advisors that I know well have already had their clients invested in commodities for the last two years, and the reason that you want to be in commodities is you can benefit from these energy stocks rising. As you probably saw in the profit reports that came out from Exxon and the major oil companies, they're just overflowing with money. As an investment advisor you want to have a percentage of the portfolio invested in energy and energy/commodities.
Is there still time to do that? I think this is a long-term phenomenon.
Do you have a projected allocation? I don't, but I think 20% in energy is probably smart.