US interest rates: It's about oil prices, stupid!

Unless there is a sharp uptick in oil prices, the US Federal Reserve is likely to push back its rate hike. The last quarter of 2015 is perhaps the earliest when it can increase rates, say Abheek Barua & Bidisha Ganguly

Will the US central bank spare us all the speculation and just say that it is unlikely to hike interest rates "for a considerable time" instead of beating around the bush (as it did in its policy statement released on January 28) and just committing to be "patient in beginning to normalise"? Should it be a little more sensitive to the somewhat dire economic situation in the rest of the world instead of focusing more aggressively than the markets expected on the economic upturn in the US? The hint that the Fed may not after all push back the date for lift-off incidentally led to a sell-off in equities and a rise in the dollar.

Let's be fair to the Fed. First, it faces the fairly peculiar dilemma of setting monetary policy for the world's biggest economy that in a curious turn of events seems to have decoupled with the rest of the global heavyweights such as China and Europe. The balance between responding to external factors and internal developments is bound to be difficult.

Second, monetary policy in the US has historically been focused on domestic macro-economic conditions and on that front, a raft of indicators do point to a recovery. Thus President Barack Obama's "tonight, we turn the page" remark in his State of the Union address to Congress on the January 20 was not all bluster. Whether he should have taken all the credit for the rising growth rate, declining unemployment and shrinking deficits is an open question. But that's the stuff of politics and the subject of another long debate.

Thus, what the Fed will ultimately do will remain the subject of speculation and the best we can offer is 'informed' speculation and list the factors that should force the Fed to push back its hike date. The most critical thing is that inflation remains well below the target level of 2 per cent. Again, despite the slew of "good data", there are little niggles like the durables data for December 2014 that turned out to be somewhat weak. The doves will see this as a chink in the recovery armour.

Another major concern is the dollar, which has risen sharply against other currencies since the European Central Bank announced its version of quantitative easing. Many US multinationals have reported weak earnings in the quarter ending December, largely due to unexpected currency movements. Raising interest rates in a world where other central banks are pumping liquidity could drive the dollar up to levels that could seriously impinge on the US economy.

We argue that what the Fed ultimately decides to do would depend a lot on how it views the decline in oil prices. A widely held view is that this will act as a stimulus to household spending and gross domestic product growth. While that is true, it might be prudent to remember some of nuances of this "oil-price effect".

The International Monetary Fund claims the real income effect is smaller for the US compared to its peers euro zone and Japan, as it now produces over half of the oil it consumes. China and India gain much more given their higher energy intensities. In short, the stimulus from oil price declines could be overstated.

Besides, the sharp decline in oil prices could also act as a deterrent to capital spending by the US oil producers. It is apparent that the crash in oil prices is already weighing on Texas' economy. The Dallas Fed recently released its monthly Texas Manufacturing Outlook Survey that showed a sharply worsening outlook for future activity.

The drop in oil prices has hurt the heavily indebted shale gas extractors and that could have a knock-on effect on the banking system. Our prognosis - unless there is a sharp uptick in oil prices, the Fed is likely to push back its rate hike. The last quarter of 2015 is perhaps the earliest when it can hike.

Abheek Barua is with ICRIER. Bidisha Ganguly is Principal Economist, CII