Why Oil price is a headache for the Fed

By Stephen Clayson
LONDON (ResourceInvestor): The gold price may be struggling to hold above $800 an ounce now but come December 11 it may be a very different story. Why? Because comments from Federal Reserve Chairman Ben Bernanke last week indicated rather strongly that another rate cut is in the offing for the U.S., and we’ll know for sure when the Federal Open Market Committee announces its next rate decision on December 11.

Bernanke said on Thursday that turbulence in financial markets over the past month or so has “partially reversed the improvement that occurred in September and October”. He also noted that recent U.S. economic data has been “on the soft side” – quite strong words for a central banker. One suspects that another quarter point cut is now almost a done deal, particularly given the weak economic data that we saw during November.

Could another half point cut be on the cards? You never know. After all, it would be of quite some benefit to the legions of U.S. consumers who are at this very moment loading themselves up on credit card debt in the hope of buying themselves a happy Christmas.

Furthermore, data released by the National Association of Realtors late last month showed that during October, sales of existing homes dropped 20.7 per cent versus one year earlier, while the median home price was down 5.1 per cent versus a year ago. The strength of the housing market is fairly crucial to the confidence of consumers and the health of the economy in general, so numbers like that make for worrying reading.

The other worry is oil. Although oil prices have come down quite significantly from their November peak of almost $100 a barrel, they are still pretty high, even adjusting for the weakness of the dollar, which pushes the nominal oil price higher without altering the real price. The prospect of $100 oil does though have an unhelpful psychological effect.

The oil price gives the Fed an inflationary headache, but it also puts a strain on the economy of the world’s biggest oil consumer. And of late, the Fed has given the impression that it prefers to look out for economic growth than to stamp on inflation as soon as it rears its head. In any case, the Fed does not feel that inflation in the U.S. has yet shown signs of accelerating alarmingly, although the trick to controlling it could well be to act before it does so.

With inflation in the eurozone, thanks in part to the greater power of workers there to secure wage increases, running quite high and the European Central Bank making quite hawkish noises, rates there are less likely to fall, meaning that the euro, the dollar’s obvious substitute, is likely to remain strong.

This will accentuate the impact of any further U.S. rate cuts. Although there has, and will continue to be, a flight into the euro as U.S. rates fall, there is also room for gold in the equation. Those who cut their teeth viewing the dollar as the anchor of the world financial system and still see the euro as an upstart currency that has yet to prove itself, and there seem to be more of them around than one might think, have only one place to go – into gold.

Gold’s recent ascent above $800 an ounce was triggered by a quarter point cut in U.S. rates at the end of October that followed on from a half point cut in September, and another cut, even of just a quarter point, will probably be all the yellow metal needs to entrench itself above $800 and maybe even break $900 in time for Christmas.