Boston Fed chief rebuts theory that rate cuts spurred oil prices

Run-up in petroleum dwarfed dollar's decline

HARWICH - The weak dollar has had little impact on the rapid rise in energy prices, Eric S. Rosengren, president of the Federal Reserve Bank of Boston said yesterday.

Although the decline in the dollar against other currencies has been a popular explanation for oil's record run, Rosengren said data show the increases in oil prices have far outstripped the pace of the dollar's decline. In the past year, the dollar has declined 13.6 percent against the euro, while a barrel of crude oil was priced at $131.31 yesterday on the New York Mercantile Exchange, up 99 percent from a year ago.

Oil trades in dollars. Many analysts say when the dollar loses value, it prompts producers to demand higher prices to offset the loss. The weaker dollar also raises demand from buyers who hold stronger currencies and investors seeking a hedge against inflation, analysts say.

But correlating oil prices with the dollar's value against other currencies shows "the cumulative change in the exchange rate pales in comparison to the enormous run-up in oil prices," Rosengren said. "In other words, the exchange rate cannot explain more than a very small fraction of the change in the dollar price of oil."

Rosengren's remarks, made at a Boston Fed conference here, rebut arguments that the Federal Reserve's aggressive interest rate cuts of the past several months have spurred record oil and commodity prices by weakening the dollar. The dollar falls when US interest rates are low because investors seek denominations with higher rates and hence higher returns.

The Fed is widely expected to stop cutting interest rates when it meets this month. Few economists, however, expect the Fed to start raising rates to fight inflation anytime soon because the economy remains weak.

Lower interest rates boost the economy by encouraging borrowing and spending. Higher interest rates, in turn, cool borrowing and spending when demand begins to push up prices too quickly.

Despite soaring energy prices, Rosengren suggested the Fed need not rush to boost interest rates. He said research at the Boston Fed shows high oil prices are not sparking broad-based inflation.

"Even if oil prices do continue to rise much faster than the US core inflation for an extended period," he said, "the experience of the past 20 years indicates that there is a relatively low correlation between oil price movements and underlying core rate of inflation."

Rosengren doesn't currently sit on the Fed's interest rate committee. Eleven Federal Reserve Bank presidents rotate among four seats on panel. As a member last year, Rosengren supported aggressive interest rate cuts to boost the struggling economy.

The Boston Fed holds its conference every year, attracting academic and business economists to share research on a variety of topics. This year, the conference is examining the relationship between unemployment and inflation.

Rosengren said economists, researchers, and policy makers need to gain a better understanding of how so-called supply shocks that send energy and food prices soaring affect inflation long-term.

That question is critical for Fed policy makers. The Fed finds itself in a tricky position: If it raises interest rates to fight inflation, it risks worsening the current economic downturn. But if it leaves interest rates too low for too long, it could spark a period of high, persistent inflation.

Among the issues economists must consider is whether to craft policies based on total inflation, or so-called core or underlying inflation, which excludes food and energy prices. For the most part, policy makers focus on core inflation, believing short-term swings in food and energy have little impact on long-term inflation.

Some economists, however, argue that higher food and energy prices are here to stay as rising global demand pressures supplies, changing inflation dynamics.

Historically, Rosengren noted, market forces have eventually reined in high oil prices as supplies rose, demand fell, and technological improvements were introduced. "That said, it seems to be taking quite a long time to date for the long-run supply and demand influences to rein in oil prices," he said. "You might say the short-run is getting longer every day."

Robert Gavin can be reached at rgavin@globe.com.