$140 oil threatens to abort the expected second-half recovery in US growth. The perennial recession forecasters have another chance of glory – though not for the reasons they suggested.

Markets have responded to mounting gloom by lowering expectations for official interest rates later in 2008 – some economists are even talking again of cuts. Yet excessive Fed easing is the prime cause of the problems the economy now faces.

As the chart shows, the Goldman Sachs commodity price index stabilised from mid 2006 as the Fed moved its target Fed funds rate above 5%. The explosion upwards started only when the Fed went into reverse and cut rates aggressively from last autumn. Prices have risen by over 60% in less than nine months – equivalent to the gain over the prior three years. Posts here in late 2007 and early 2008 argued that the Fed’s policy was misguided and would fuel inflation rather than stimulate the economy.

Commodity prices – particularly energy – may now be above the level needed to equate demand and supply over the medium term. Markets that overshoot fundamentals sometimes fall back to earth just under the weight of their overvaluation. More usually, a tightening of monetary conditions is necessary to trigger the adjustment. For example, the TMT bubble of the late 1990s burst only after the Fed raised official rates from 4.75% to 6.5%.

The Fed has damaged the economy by buckling to the demands of Wall Street interest rate doves. A commitment to a stable dollar, backed up if necessary by policy tightening, would be the best route to a recovery. More of the same is a recipe for continuing woes.

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