The basic definition of a recession is two straight quarters of declining economic output. It’s currently believed that that definition has not been met meaning we aren’t officially in a recession. Regardless Ben Bernanke, our Federal Reserve Chairman, recognizes that the country is hurting. As reported by the Wall Street Journal Bernanke recently told the House
Whether it’s a technical recession or not is not all that relevant. It’s clearly the case that for a variety of reasons families are facing hardship.
Among those reasons are “ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities,” according to Bernanke.
Housing is certainly a big issue but I believe rising oil prices are what’s hurting us the most right now. Besides gasoline, oil prices are affecting all other consumer goods. Any industry that needs gas or oil, which is about all of them, is affected by the mushrooming oil prices. In turn these industries have to raise their prices to help cover the costs. And since prices have been rising for so long now, with no real expectation of them dropping, industries are building their new price structures with the expectation of high prices to continue.
And who pays those prices? We do! Or we don’t and industries get hurt further by not selling their products.
So what’s the Fed to do?
The major tool the Fed has is the ability to raise or lower the nominal Federal Funds rate. This is the rate that sets what it costs for a bank to borrow money from another bank. Why would a bank borrow money? By law a bank is required to hold a certain percentage of it’s bank demands as reserves. If a bank’s reserves fall below the required percentage then the bank must borrow cash to brings it’s reserves back up.
What does that all mean? When the Fed lowers rates they make it easier, or more advantageous, for a bank to borrow and lend money (it’s cheaper to borrow). This in turn means it’s cheaper for firms to borrow from banks for things such as investing in the growth of their company. A company is more likely to build up when borrowing is cheaper (think of it this way: you’re more likely to finance a new car if your loan has a low interest rate).
Sounds great right? Why not keep the rates permanently low so business is always growing? Problem is as businesses grow inflation rises. As there’s more money available there is more demand for products so companies raise their prices to match demand. Basically the cost of a growing economy is inflation. Ideally you don’t want the economy to grow too fast because prices will rise fast as well. What the Fed does in this case is raise the Federal Funds Rate to slow economic growth which in turn slows inflation.
You can see it’s a fine balancing act for the Fed to determine their rates. Set rates too low and you get inflation. Set rates too high and economic growth is stunted.
And then come oil prices! I think the Fed could fix the economy easily if not for the rise in oil prices. No matter what the Fed does, rising oil prices cause all other prices to inflate. If the Fed raises rates to help lower inflation then economic growth is hurt. Less economic growth means less jobs for the rest of us. If the Fed raises rates to encourage economic growth then they risk ballooning inflation on top of riding oil prices.
I’m not sure there’s an easy answer here. We may have to just get used to the fact that oil prices will remain high and hope that they stop rising so fast. If oil prices stabilize the rest of the economy will have time to catch up. In the end we’ll be ok but it’s going to hurt us for now.
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FFB- Good take on the issues that the Fed is dealing with, as well as how they are inter-related. Hopefully the drop in oil prices (and rise in the stock market) over the last couple of days will continue!
HHhhhmmm…and I heard something from CNN that oil will continue to oil prices will continue to rise for the next 5 yrs!
I really think its time to drill oil within US shorelines.
Sam
Fix My Personal Finance
http://fixmypersonalfinance.com
Fannie and Freddie seem to be the life of the part these days. And Congress is currently debating to give the Fed more power and the ability to actually purchase shares of the two mortgage giants in addition to lending money. Sen. Bachus had a great quote on the issue saying something like it’s strange how Fannie and Freddie privatize their profits but when it trouble socialize the losses.
Along with oil, however this issue is decided may be a major swinging point in either direction as far as the economy goes. great post.
This is a very insightful post. It appears that you have an economics background. Thanks for sharing!
This was an interesting post. Thank you for sharing it. This whole recession thing is new to me because I am still fairly young and I don’t remember experiencing anything like the economy we have today. It appears that now is the best time to seriously start to consider alternative means of accessing energy. There must be a cheaper and cleaner way… but what is it?
Yea, we’ve had troubles along the way, but nobody really has a clear definition of the answer. We’ve been in recession before and gotten out, even depression; but I think that mixing things up in the government is really going to drive some change.
I’m no political genius, but I figure that Bush is backed into a corner and can’t pull out of oil rich countries because of $ and pride now. He’s said that he’ll fix the issue and continue to say everything is going as planned till he leaves. If he pulls out now it says the US couldn’t handle it and it may look bad everywhere else.
On the other hand, come November whether it be Obama or McCain, they can pull the troops out and just say it wasn’t in their plans and egg won’t fall as hard on anyones face then.
I think we’re in for it until at least that time… Fingers crossed…
Hello,
I am a new reader to your blog. I subscribed to your RSS feed and I look forward to your future posts (I will probably be diving through the archives in the next few days).
You have a pretty cool blog. You should check out mine…its on the wealth tips of a struggling entrepreneur
Popped a link to your article on my website (above). Can’t believe how fast your site spotted the link!
Good article. Cheers
@ RC - Haven’t kept up with the market. Hope you’re right about the oil prices. If they could at least stabilize a bit we would be in better shape.
@ Sam - I would expect oil prices to continue to rise over five years but it’s the pace that it’s rising that’s hurting us. It’s rising much faster than inflation and firms can’t keep up. Not sure US drilling is the answer.
@ Frank - I wouldn’t be surprised to see Sallie Mae in the news next. I think those issues can be handled easier than oil though.
@ Almost Millionaire - I took a macroeconomics course last semester. I’m no expert though.
@ Alisa - Not sure anyone has seen an economy quite like the one we’re in. Alternative energy is certainly something that needs to be looked into long-term.
@ Hank - I will be interesting to see what goes in in the coming months leading to the election and what happens after. Oil will definitely play a part in the coming elections.
@ Ryan - Thanks for the kind words. I’ll definitely check out your site!
@ Colin - Thanks!
These are good guiding principles. It would be nice for our society to find a workable alternative solution that way, we don’t have the dependence on oil that affects prices of goods across the board.
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