Bernanke's Kryptonite

Includes: APA, BHP, CVX, OXY, XOM
by: Eric Parnell, CFA

How do you stop a man from printing another $1 trillion of the global reserve currency? This is seemingly an impossible task to achieve. With inflationary pressures still subdued, the U.S. Federal Reserve remains compelled to act as aggressively as possible in an ongoing effort to jump-start the economy and bring down stubbornly high unemployment. Never mind that the $2.3 trillion already printed by the Fed since the outbreak of the financial crisis several years ago has not resulted in a sustainably strong economic recovery to this point. Perhaps another $1 trillion or more will finally do the trick. But what are the unintended consequences to these repeated and extreme actions? And what if anything can finally grab the attention of the Fed to put a stop to the money printing? Oil may ultimately prove to be the kryptonite that finally weakens the resolve of Chairman Bernanke and the Fed's printing press.

Is Inflation Really Under Control?

This is an important question to consider before going any further. At first glance, it appears that inflationary pressures are benign. Two well-known and widely used measures of inflation illustrate this point. These are the U.S. Consumer Price Index (CPI) reported by the Bureau of Labor Statistics (BLS) and the Personal Consumption Expenditure (PCE) price index compiled by the Bureau of Economic Analysis (BEA). Both are derived using statistical methodologies in an effort to best estimate changes in the price level of consumer goods and services over time. And an examination of both of these measures strongly suggests that inflationary pressures are under control and pricing stability reigns, with the year over year change in prices for both measures both comfortably between 1% and 2%.

The core inflation readings that exclude the more volatile food and energy components reinforce further the idea that inflation is under control. And these core figures are particularly important for these are the readings that the Fed relies upon to monitor pricing pressures.

However, the fact that both the CPI and PCE suggest that inflation is under control does not necessarily end the discussion. It is important to note that both readings are based on statistical models that are designed to estimate changes in prices to the best of their ability. And I have no doubt that those who have constructed and are maintaining these models at the BLS and BEA are applying what they have determined to be the most statistically accurate assessments of pricing. But it is important to still point out that these are still estimations and not necessarily statements of fact. For how a model is constructed and the inputs used can lead to output that can vary widely over time.

For example, John Williams at provides alternative inflation charts focusing on the CPI. Recognizing that the BLS changed their estimation methodology in both 1980 and 1990, he provides a look at how inflation would look today if these previous models were still in use. Under the pre-1990 model, inflation today would not be considered under control but instead running fairly hot at over 5%.

And under the pre-1980 model, the talk today would likely be about the return of 1970s style stagflation, not relative pricing stability.

These examples do not necessarily suggest that we have an inflation problem today. But what they do suggest is the possibility of an inflation problem that may already be lurking undetected under the surface. Of course, any conclusions about prices depend on the measuring methodology in the end.

And who among the average consumer can really argue with the Fed's conclusions about price stability anyway. Even if it feels like we may be paying much more for goods and services than we did in the past, each of us are only one in a vast population of consumers and are limited in our ability to clearly demonstrate that we actually have an inflation problem today. It's not as though we have a billboard that announces the daily price of goods and services in our economy. This is true, of course, with the exception of one key item that all Americans need to consume every single day.

What About Oil?

Let us move forward under the assumption that pricing pressures are under control, since this is what the Fed is seeing in their models. What then has the potential to rattle the Fed's cage on the inflation front whether it shows up in the official statistics or not? This product is oil. And higher prices related to oil are already arriving at a gas station near you thanks to the Fed's latest QE3 stimulus program.

The fact that the Fed largely ignores food and energy prices in focusing on the core inflation readings instead is another subject for debate in the statistical modeling process. The justification for excluding these two items is based on the notion that both categories experience highly volatile price swings that fail to persist in a sustained price change over time. But here's the problem. Whereas price changes in these categories may not have persisted over time in the past, they have absolutely persisted over the last decade.

An examination of energy in particular highlights this point. From the early 1980s up until the year 2000, energy prices would experience wild short-term swings (the blue line on the chart above) but underlying prices would remain relatively stable (the red line on the chart above). This, of course, began changing dramatically at the start of the new millennium, as the violent price swings were not neutralizing themselves out as they had in the past but instead have been accumulating into sustained price increases at a rate of +7.5% per year on average over the last decade. Putting this in simpler terms, the price of gasoline was still consistently below $2 per gallon in the U.S. back in 2005. Eight years later in 2013, the notion of seeing gasoline below $3 per gallon seems far-fetched. And the prospects of gas prices rising sustainably past $4 per gallon or even $5 per gallon in the near-term are more than realistic.

In short, it is difficult to continue looking past food and energy prices when assessing inflation, for the increases in these categories are not only persisting but are also increasingly serving as a tax on the purchasing power of consumers.

Unfortunately, the Fed is stoking the fire under energy prices with its latest QE3 stimulus program. It is not just stock prices that float higher day after day completely drunk on Fed liquidity. It is also energy prices including the staple commodities of oil and gasoline. And dating back to the beginning of the financial crisis, when the Fed has engaged in a QE stimulus program, energy prices including gasoline have floated steadily higher.

An important distinction is worth noting about QE and asset prices. It's not just any QE that gooses the prices of stocks and commodities higher. Instead, it is specifically U.S. Treasury purchases by the Fed that causes the market melt ups, for this specific strategy provides the daily injections of liquidity that float the markets higher almost daily. This is why the latest QE3 program launched in September 2012 was falling flat in asset markets until recently, for it was not until Treasury purchases commenced at the beginning of January 2013 that asset prices began steadily inflating.

Since the start of the year, the rise in gasoline prices has been both sharp and persistent. Heading into 2013, the spot price of unleaded gasoline was lingering between $2.70 and $2.80 per gallon. But once the forces of QE finally latched on to gasoline prices starting on January 17, the subsequent rise has been almost relentless. Over the past month, unleaded gasoline prices have risen in 18 out of the last 22 trading days. The cumulative effect has been a +20% rise in the spot price so far this year.

In short, the Fed's dogged efforts to try and increase stock prices for the roughly half of Americans that own stocks today according to a Gallup poll in order to create a wealth effect that just might marginally increase economic growth at some point down the road is coming at a cost of effectively taxing all Americans today who rely on gasoline to drive their cars and petroleum products to heat their homes. No wonder we have yet to see any sustained benefit to the economy from QE to date. Perhaps it is even hurting more than helping at this stage.

The Fed's Pain Threshold For Higher Gas Prices

The folks at the Fed are smart people. They have to know that QE is directly juicing not only stock prices but also energy prices including gasoline. And unlike nearly all other goods and services in our economy, the price of gasoline is one that is projected on big billboards throughout the streets of our respective towns each and every day. And while companies can narrow the width of men's ties, cut down the length of toilet paper rolls and shrink the size of popsicles in order to hide price inflation in most other parts of the economy, a gallon of gasoline is always going to be a gallon of gasoline. Thus, the price at the pump is the one key data point on inflation where there is absolutely nowhere to hide. The price of gasoline is announced loudly each and every day, and it is critical to wonder exactly what the price threshold will be when consumers begin to riot.

Looking ahead, it is highly likely that we will see $4 per gallon gasoline perhaps as early as the spring. And a run at $5 per gallon is certainly possible by the time we are in the midst of the peak summer driving season. While it is almost a given that the completely nonsensical, absolute garbage political rhetoric about greedy oil companies will return to our airwaves if and when this gasoline price rise occurs, the truth will remain that the blame for the rise in energy prices will almost entirely rest at the feet of the Fed. And whether they say so or not, they are smart enough to know that this is true.

So exactly what gasoline price point sets off public alarms remains to be seen. But it will become increasingly difficult for Fed officials to justify to the American people that we do not have an inflation problem when gas prices at the pump are screaming higher. And this will be true whether the Fed is receiving the blame for the price rise from the public or not. Whether the rising price of gasoline ultimately proves to be Bernanke's kryptonite for further QE will be a critical theme to watch as we move into the middle part of the year.

In the meantime, it is worthwhile to prepare your portfolio for such an outcome. And focusing on oil and gas stocks that are highly correlated with rising energy prices is an attractive theme. Representative names include Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), Occidental Petroleum (NYSE:OXY) and Apache (NYSE:APA), the last of which was absolutely drubbed late last week and is now oversold on a variety of technical readings. BHP Billiton (NYSE:BHP) is another attractive offering for a more diversified energy and mining allocation.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long XOM, OXY, APA, BHP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.