Former Kansas City Fed Chief Thomas Hoenig had warned about the possibility of a systemic shock at a time when we don’t have the ability to respond, due to already historic low interest rates.
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I believe we are facing the possibility of just that happening within the next year or two.
Hoenig’s biggest fear has been a systemic shock -- specifically a rise in oil prices -- that causes a recession and inflation, with the Fed having to respond by raising interest rates as the global economy slows.
Oil prices are hovering around $100 and we are facing a very uncertain 2012 in the Middle East. The US has withdrawn from Iraq, allowing for sectarian violence and a developing proxy war between the Saudi Arabia/Sunni world and Iran/Shia world.
Iran is facing tough economic times and President Ahmadinejad is feeling the heat of his reforms of lowering subsidies on gas and oil in 2009. Iran is the second largest consumer of gasoline in the world behind the US, but Iran does not have a real economy due to falsely depressed fuel prices. A reported 17% of fuel is smuggled abroad because Iranians can buy it so cheap in Iran that they buy it and smuggle it out of the country.
Ahmadinejad is trying to change that because he knows it is unsustainable, however a doubling or tripling of oil prices to a more realistic level will lead to a crippling of the economy combined with sanctions, social unrest and high unemployment. Numbers for total subsidies run as high as $100 billion annually from the Iranian government, with some experts saying it is more like $30 billion for energy. Iran has a $347 billion total budget.
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The IMF has predicted a rise in inflation of 32% due to these subsidies being phased out and Iran is already dealing with high unemployment and high inflation. Iran is in trouble, which leads us right back to why the situation is likely to get worse.
Iran has long sponsored Shia militia in Iraq. The Kurd region is probably safe from Iran control, but the middle and southern oil fields are in play if Iraq is destabilized. A nuclear Iran is a danger to the region, and the world. Saudi Arabia already refers to the nuclear bomb as a ‘Sunni bomb’ in reference to the perceived target.
I believe there is a good possibility that Hoenig’s greatest fear is going to start being played out this year or next.
An escalation of tensions -- a bombing of Iran by Israel, or increased sanctions -- will likely cause Iran’s hand to be called. How they respond will be critical -- if they come to the table it could be resolved, if not (the most likely scenario in my opinion), this gets worse and oil prices spike.
If oil prices spike and the EU does not get settled the US could be facing high inflation with a recession, forced to either watch inflation rise or raise rates into a recession, the worst case scenario.
I hope this time Hoenig’s warnings and advice are not ignored.