Tipping Point

Did you feel it?

Something happened in the stock market and the economy last week that has important political and geopolitical implications. First, some basic background. In addition to setting interest rates, the Federal Reserve maintains a pool of daily liquidity that essentially acts as high-octane fuel for the capital markets. By varying the size of this liquidity pool, the Fed determines how much "juice" is available to go into various financial instruments. On a daily basis, this influences liquidity far more than interest rates, which are less targeted and work with a lag. Since any asset trades as a function of supply and demand, the more liquidity the Fed creates, the more demand there is for stocks, bonds and other assets.

Since the bursting of the technology bubble in 2000, there have been four distinct periods in which the Fed has flooded the system with an extraordinary amount of liquidity in an effort to boost the stock market:

1. Immediately after 9/11.
2. During the second half of 2002 in response to widespread accounting scandals and the meltdown in the corporate bond market.
3. During the summer and fall of last year, just before the presidential election (draw your own conclusions).
4. The past two months.

This usually works pretty well; the Fed deliberately raises the level of its liquidity pool, money flows into the capital markets, and demand increases for stocks. This dynamic is not foolproof, however; the Fed can create the juice, but it cannot determine exactly where it goes. Due to a confluence of factors---the Fed goes overboard, investors' risk preferences change, etc---all that extra money sometimes flows into other things like precious metals or crude oil.

In my opinion, this has been as much a factor in the recent spike in crude oil as anything else. Yes, demand from China is increasing. Yes, the actual supply of oil is decreasing. But both have been happening for years, and neither alone nor combined can they account for the degree of oil's recent rise. It's obvious that liquidity has been a major factor; over the past few months it has reached historic levels, even as the Fed has continued to raise interest rates. It explains the seemingly incongruous concurrent rise in stocks and bonds and oil, which has left many market participants---and the business media---shaking their heads in bewilderment. Excess liquidity is also a major reason why gold is at a multi-month high.

Like politics, monetary policy is the art of the possible. One truism of the financial markets is that there is no free lunch; for every action, there is a reaction. The Federal Reserve does what it can get away with until something forces it to change course. And that something appeared to happen this week. When oil hit $60, the stock market sent a clear message that the tipping point had been reached; above $60, the effect on the economy is enough to prevent stocks from continuing to rise in tandem with oil. A microcosm of this was Federal Express, which fell over 8% on Thursday after citing the impact of higher fuel prices on its business. Other companies in various industries are finding it increasingly difficult to pass along higher input prices to customers.

The Federal Reserve can either damn the torpedoes and continue to inflate, in which case oil will head quickly for $100 and beyond as Goldman Sachs recently predicted. Or it can continue to raise interest rates as well as lower its temporary liquidity pool, and in the process address one factor behind the rise of oil. But draining liquidity is not without risks; because of the Fed's past miscues, our economy has become like that bus in the movie "Speed" which can't slow down. Which course will the Fed choose? Based on its actions over the past few days, it appears the Fed will try to drain slowly and hope for the best; the equity market appeared to recognize that last week. If the Fed does drain and oil does not respond, we are indeed in uncharted and extremely dangerous territory.

Of course, all this illustrates just how much of an Achilles heel oil is for our economy. If we controlled all the oil on the planet, a major constraint on our monetary policy would not exist. But that's not the case, and we must buy it from others. And as long as those sellers can hear our printing press running full bore, they will continue to demand more paper from us for their ever-dwindling and only natural resource.

This has important implications beyond the stock and commodity markets. Despite the fact that the Federal Reserve is supposed to be independent politically, records indicate that Alan Greenspan has been visiting the White House at an ever-increasing rate---far more than he has during any other presidency. One can be absolutely sure that Bush and his advisors are well aware of the liquidity dynamic as well as the Federal Reserve's intentions. If Greenspan has indicated to the White House that the limits of Federal Reserve policy have been reached because of the crippling effect of any further rise in the price of oil, that will influence political and geopolitical strategy. Will the White House sit by idly, knowing that as Greenspan drains liquidity the economy will slow and the stock market will likely fall? Is inaction an option when opinion polls are already low and Iraq is a nightmare? Or was Karl Rove's outburst the opening salvo in a dog-wagging campaign of distraction?

If you can think like a cornered politician or a statist Fed banker, you might be able to anticipate what happens next.