“What do you think will happen with interest rates?”
“They will fluctuate.”
“Could you be more specific?”
“They will fluctuate up and down!”
That little exchange may be familiar to anyone who has listened to Gary Stern, president of the Federal Reserve Bank of Minneapolis give a public talk.
Someone from the audience always wants to hear about interest rates right from the horse’s mouth. Stern, who has represented the Minneapolis Fed at Federal Open Market Committee meetings for 17 years, knows how the media will run amok with any comment he might make about rates. He wisely gives an answer that is completely true, though not necessarily satisfying: Interest rates will fluctuate up and down.
Keep that example in mind as we pass from latent to active war in the Middle East. Oil prices and stock prices will fluctuate — up and down.
U.S. stock markets seemed positively euphoric last week Friday and this Monday as it became clearer that the long period of uncertainty about U.S. action against Iraq seemed to be coming to a close. The Dow was up nearly 7 percent in two trading days. But Tuesday and Wednesday saw little change
A few leftish commentators cited the Friday-Monday market spike as evidence that the U.S. industrial and financial sectors anticipate “obscene profits” from any war. This is silly. The economic effects of direct military spending for the Iraq war and any follow-up “nation building” are likely to be small relative to a near $11 trillion economy. The stock market increase was a direct reaction to reduced uncertainty.
The effects of higher or lower oil prices on the U.S. economy are greater than military spending at current levels. World crude oil prices remain high and volatile. In the United States, gasoline prices have reached historic highs in nominal terms, but not if one adjusts for inflation.
With oil, as with equity markets, uncertainty plays a powerful role. Uncertainty motivates investors to be cautious and not buy something as risky as a share of stock. It is better to keep the money in the bank, bonds or a money market account. Stock prices stay in the doldrums.
Uncertainty has the opposite effect on oil prices. If you have crude in hand, you can sell now or sell later if prices are higher. Physical quantities available (which is very different from what economists mean by “supply”) are low relative to usage right now, so only a little holding back in response to uncertainty can increase prices significantly.
We may be at war by the time this column is printed. For the sake of U.S. troops and the Iraqi people, one hopes that the war will be short. But even if initial fighting is very successful and U.S. and other allied forces gain effective control of Iraq in “days, weeks or months,” substantial uncertainty will still remain.
There will be fears about possible follow-on terrorist attacks in the United States or elsewhere. A small bombing or chemical release with limited casualties won’t harm the U.S. economy in any measurable way, but will keep citizens and markets jittery. A larger attack, on the scale of Sept. 11, 2001, or greater would be a blow to economic sentiment. I think the odds of this are very small, but, in the truest sense of uncertainty, no one knows what the likelihood is of any minor or serious incident.
A quick defeat of Iraqi forces similarly will not be the same as long-term success. It is entirely likely that war advocates and war opponents will both be right to a degree. The overt war may go quickly and many Iraqis may welcome an overthrow of Saddam. But even if a majority of Iraqis regard an overthrow of Saddam as “liberation,” getting to a situation where U.S. troops can withdraw is likely to be extensive. As long as they are in the country, they may be attractive targets for Iraqis or others who see the U.S. as an oppressive hegemony.
If, as optimists assert it may, the occupation of Iraq follows the peaceful pattern of the U.S. Military Government in Japan following World War II, oil prices will drop and consumer and business confidence will recover. Equity markets may regain substantial ground, though not to the stratospheric levels of 1999.
On the other hand, if an occupation of Iraq ends up like the U.S. occupation of the Philippines following the Spanish-American war, with the bloody and divisive three-year suppression of Philippine insurgents, then household and investor confidence may drop lower still. That will take a continuing toll on equity prices.
Oil prices are likely to drop once open hostilities end and there is no immediate threat to oil facilities in the Persian Gulf region generally. Even if there is some drop in Iraqi production itself, that will not keep prices high except in the short run.
Summary: Gasoline prices probably are near their peaks, unless war damage in the Gulf is large. But substantial increases in stock indexes are a longer shot.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.