Recessions are associated with both rising oil prices and increases in the federal funds rate. Are recessions caused by the spikes in oil prices or by the sharp tightening of monetary policy? The authors discuss how to disentangle these two effects.Petroleum products - Prices ; Monetary policy

Charles T. Carlstrom

Timothy S. Fuerst

English

Research Papers in Economics

how the economy typically behaves if
both oil and the funds rate increase.
(Some economists have questioned
whether BGW’s estimates remain valid
or stable in the most recent period, from
1983 to the present).
Figure 2 contains BGW’s empirical esti-
mates of the impact a 10 percent oil
price shock would have on GDP if the
funds rate increased with oil price hikes.
Because oil price changes tend to have
asymmetric effects, BGW focus only on
oil price increases that exceed anything
experienced over the previous four 
quarters. The analysis suggests that a
one-time increase in oil prices and the
ensuing funds rate increase would lower
GDP by 0.7 percent. But part of this
decline would probably result from the
increase in the funds rate. Specifically, 
a one-time hike of 10 percent in energy
prices is typically associated with a 
150 basis point increase in the funds
rate, designed to head off a rise in 
inflation. To disentangle these two
effects, BGW ask how much output 
typically declines after the funds rate
increases by 150 basis points.
With this information, they estimate the
impact on output of a 10 percent energy
price hike under the counterfactual 
July 2005
Federal Reserve Bank of Cleveland
Oil Prices, Monetary Policy, and the
Macroeconomy
by Charles T. Carlstrom and Timothy S. Fuerst
ISSN 0428-1276
Recessions are associated with both
rising oil prices and increases in the
federal funds rate. Are recessions
caused by the spikes in oil prices or
by the sharp tightening of monetary
policy?  The authors discuss how to
disentangle these two effects.
Every recession since 1971 has been
preceded by increases in the price of oil
and a rise in the federal funds rate 
(figure 1). Are recessions caused by
spikes in oil prices or by a sharp tighten-
ing of monetary policy? Or are they
caused by a confluence of both factors,
the so-called “perfect storm”?
This Commentary discusses the efficacy
of different federal funds rate move-
ments in response to oil price shocks.
Such movements may be direct
responses to oil prices or, more likely,
indirect responses. For example, a shock
to energy prices tends to increase infla-
tion, so that an inflation stabilization
objective would lead to increases in the
federal funds rate. To investigate the
appropriate policy response, we must
gain some idea of the differing eco-
nomic impacts of oil prices and funds
rate movements. Hence, this Commen-
tary first discusses how to disentangle
the contributions of oil price increases
from those of funds rate increases. Some
have argued that the problem is less the
oil shocks per se than the Federal
Reserve’s tendency to increase the funds
rate (either directly or indirectly) in
response to these shocks. 
There are two approaches to disen-
tangling the impacts of oil prices and
funds rate movements on the typical
recession: empirical modeling and theo-
retical modeling. Both of them attempt
to answer the counterfactual question,
“How much would output have fallen if
the Federal Reserve had kept the funds
rate constant in the wake of the oil price
shock?” We argue that the empirical
approach, which has formed policy dis-
cussion, does not handle expectations
very well. Empirical work estimates
changes based on historical data, but
these data are formed by the public’s
expectations of how the Fed will
behave. If these expectations were to
change, however, the future might be
very different from the past. 
That is, the empirical approach to
answering the counterfactual question
investigates how far output would have
fallen after an oil shock, under the
implicit assumption that the public
expects interest rates to increase in
response to that oil shock, as they have
in the past. The public is thus surprised
when the Fed keeps the funds rate con-
stant in the wake of the oil shock. But if
the Fed were to stop responding to oil
shocks, and the public understood this
policy change, the answer to the counter-
factual question might be far different.
Using a theoretical model to address 
the effect of such an anticipated policy
change, we conclude that deviating 
once, and not allowing the funds rate to
increase, could have some advantageous
effects. But it would be unwise to 
deviate repeatedly, because once such 
a policy is anticipated, the presumed 
output gains of the constant funds rate
policy disappear. 
■ Disentangling Oil Price Hikes
and Funds Rate Hikes 
In an influential article, economists
Bernanke, Gertler, and Watson (BGW)
approached the issue of how to disen-
tangle oil and funds rate increases by 
asking the counterfactual question,
“How much would output have fallen if
the Federal Reserve had kept the funds
rate constant in the wake of the oil price
shock?” As a first step, BGW estimateU.S. production. We use the average
share but, because this share has
shown a secular decline, our model
probably overestimates oil’s current
impact on the economy. The model
also ignores potential asymmetries
in the impact of oil price move-
ments. Finally, the model includes
the assumption that the Federal
Reserve raises the funds rate in
response to increases in inflation.
That is, the Fed’s response to energy
is only indirect. This indirect effect
is what leads to a tightening of pol-
icy in the wake of an oil shock. If
our model’s estimates are to be taken
seriously, they should be roughly
similar to those in figure 2. 
Figure 3 shows the model’s estimate
of the effect that a 10 percent oil
price shock would have on real 
GDP. The baseline experiment
allows the funds rate to increase in
response to the oil price hike. In
contrast to the empirical analysis,
where the impact of a 10 percent oil
price shock (and the ensuing funds
rate increase) causes output to fall
around 0.7 percent, we estimate the
effect to be nearly 0.5 percent. Simi-
larly, the empirical estimate was 
that the funds rate would rise by 
1.5 percentage points in response 
to the oil shock. Our model esti-
mates the change to be about 2.0
percentage points.  
Figure 3 also illustrates our model’s
estimates of the effect that a 10 per-
cent oil price increase would have
on the economy if the funds rate
were held constant when the public
expected it to rise. Like the empiri-
cal estimates, our model suggests
that the negative impact of oil on
real GDP would be muted consider-
ably. Instead of declining by 0.5 per-
cent, it would fall by 0.2 percent. 
Taking these factors into considera-
tion, we believe that our small-scale
theoretical model is roughly consis-
tent with the empirical estimates.
The advantage of our model, how-
ever, is that it also allows us to 
analyze the anticipated-policy exper-
iment, in which the public under-
stands that the funds rate will no
longer rise in response to energy
price shocks in order to keep infla-
tion from rising. This experiment
was not performed by BGW; it
would be difficult, if not impossible,
FIGURE. 1 OIL PRICES 
AND EFFECTIVE FEDERAL
FUNDS RATE
0
2
4
6
8
10
12
14
16
18
20
3/71 3/75 3/79 3/83 3/87 3/91 3/95 3/99 3/03
0
5
10
15
20
25
30
35
40
45
50
Percent, quarterly average
West Texas intermediate crude oil price
Dollars per barrel
Effective federal funds rate
NOTE: Shaded bars represent recessions.
SOURCE: Charles T. Carlstrom and Timothy S. Fuerst.
2005. “Oil Prices, Monetary Policy, and the Macro-
economy,” Federal Reserve Bank of Cleveland, Policy
Discussion Paper,no. 10.
FIGURE 2. RESPONSE TO
AN OIL PRICE SHOCK
12 3 4 567 89 1 0 11 12 13 14 15 16 17
–0.8
–0.7
–0.6
–0.5
–0.4
–0.3
–0.2
–0.1
0
0.1
0.2
Base scenario
Federal funds rate constant
Percent
Quarters
RESPONSE OF REAL GDP
–0.6
–0.4
–0.2
0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
12 3 4 567 89 1 0 11 12 13 14 15 16 17
Quarters
Base scenario
Percent
RESPONSE OF FEDERAL FUNDS RATE
NOTE: Sample is 1965:IQ–1995:IVQ.
SOURCE: Ben S. Bernanke, Mark Gertler, and
Mark Watson. 2004. “Oil Shocks and Aggregate
Macroeconomic Behavior: The Role of Monetary
Policy: A Reply,” Journal of Money, Credit, and
Banking, vol. 36, no. 2, 287–91.
scenario in which interest rates
did not increase but were held
constant at pre-shock levels. The
implicit assumption in this calcu-
lation is that the public antici-
pated an increase of 150 basis
points and would be surprised
when no policy move occurred. 
Their empirical analysis con-
cludes that raising the funds rate
would be expected to decrease
output by 0.3 percent. Hence out-
put’s fall in the wake of the oil
shock would have been muted
considerably if interest rates had
been held constant; specifically,
output would have declined only
0.4 percent. 
It is instructive to put these num-
bers into context. Given that oil
prices increased 30 percent
between the first quarter of 2004
and the fourth quarter of 2004
(from $33 to $45 a barrel), one
would expect that if the funds rate
were allowed to increase as in past
episodes, output would decline by
2.1 percent. If the funds rate were
held constant, however, BGW’s
analysis suggests that the same
shock would reduce output only
1.2 percent. The difference in
these two estimates is that a one-
time oil price hike of 30 percent
typically is associated with a
funds rate increase of nearly 
450 basis points. 
■ Oil Prices and 
Monetary Policy:
Some Simulations
The analysis made above holds
policy expectations fixed when
conducting the counterfactual
exercise. This may help us under-
stand the effect of an unexpected
one-time policy shift, but does not
necessarily help us understand a
systematic policy change that is
likely to become expected. Since
expectations are not directly
observable, we cannot use empiri-
cal analysis to understand the
effects of a permanent, systematic
change in policy. But a theoretical
model allows us to conduct such
an experiment. 
The model assumes that oil is
used in producing output and that
the model is calibrated to match
evidence on the share of energy inoutput relative to both the baseline and
the anticipated-policy experiments. In
the theoretical model, nominal prices
and wages are very sticky, so unexpected
inflation has a large output effect. In
short, the surprise stabilization of the
funds rate has a larger output effect than
does the anticipated rate change.
■ Conclusion and Policy
Implications
This paper presents evidence about the
likely effect of an oil price shock on
output and inflation. We do this by
modeling two hypothetical relation-
ships between oil and the funds rate—
one in which the funds rate increases
endogenously because of oil’s impact
on inflation and output, and one in
which the Fed actively offsets this rate
increase by holding the funds rate con-
stant. Furthermore, we show the effect
of the latter experiment under two dif-
ferent scenarios—one in which the Fed
engineers the constant fed funds rate by
systematically surprising the public 
(as is typically assumed in the empirical
work), and another in which the public
understands that the Fed will no longer
allow short-term interest rates to
increase in response to energy price
hikes. By “surprising the public” we
mean that the public expects the Fed to
follow its policy rule, which calls for it
to raise the funds rate, but the Fed
keeps the rate constant instead.
Our unanticipated-policy experiment,
in which the public is surprised, had
output declining by a small 0.2 percent
in response to a 10 percent hike in
energy prices. Once this policy became
anticipated, however, the output decline
increased to 0.5 percent. The output
response to a 10 percent oil price shock
is essentially the same as it was in our
baseline experiment, where interest
rates were allowed to increase in
response to rising oil prices. 
The policy implication of this differ-
ence is clear. Our experiments suggest
that delaying further increases in the
funds rate could help the economy
through any potential “soft patch”
caused by recent oil price hikes—with-
out increasing the chance of inflation—
but that the gains from such a change
may be short-lived. Our anticipated-
policy experiment demonstrates the
downside of such a policy choice. The
only reason that holding the funds rate
constant substantially mitigated the
output decline is that the public didn’t
expect the Fed to do it. It might work
once, but if the same response to oil
price increases is given every time, it
will eventually be anticipated by the
public and do nothing to mitigate the
output decline. 
FIGURE 3. SIMULATED INFLATION, OUTPUT, AND NOMINAL INTEREST RATE AFTER AN OIL PRICE SHOCK
–0.8
–0.4
0
0.4
0.8
1.2
1.6
2.0
01 3 5791 1 1 3 1 5 1 7 1 92 1 2 3
INFLATION
Baseline
Federal funds rate constant, unanticipated
Percent
Federal funds rate constant, anticipated
Quarters
–0.6
–0.5
–0.4
–0.3
–0.2
–0.1
0
0.1
0 1 3 5 7 9 11 13 15 17 19 21 23
Percent
Federal funds rate constant, unanticipated
Federal funds rate constant, anticipated
Baseline
OUTPUT
Quarters
–0.8
–0.4
0
0.4
0.8
1.2
1.6
2.0
2.4
0 1 3 5 7 9 11 13 15 17 19 21 23
Percent
Federal funds rate constant, unanticipated
Baseline
Federal funds rate constant, anticipated
NOMINAL INTEREST RATE
Quarters
to perform empirically because expecta-
tions are not directly observable. But in
our theoretical model, it is a simple mat-
ter to alter the public’s behavior so that
the policy change is anticipated. Our
experiment with anticipated policy pro-
duces very different results: It suggests
that if the public correctly anticipates
that the central bank will not systemati-
cally respond to oil price movements
but will keep the funds rate stable, the
economy contracts by roughly as much
as in the baseline case. Thus if the Fed
had systematically held the funds rate
constant after every oil shock, output
would have declined by an amount
comparable to the decline actually
observed. 
The behavior of inflation explains 
this result. In all three cases, the oil
price increase leads to an immediate
increase in inflation. In the baseline and
anticipated-policy experiment, the sub-
sequent inflation movements are fully
anticipated, so the output responses are
similar. In the unanticipated-policy
experiment, however, the level of infla-
tion exceeds anticipations. The level of
expected inflation is given by the base-
line case because the public expects 
the central bank to raise rates. However,
the actual level of inflation exceeds
expectations when the funds rate is
unexpectedly kept constant. This unex-
pected inflation leads to an expansion of
SOURCE: Charles T. Carlstrom and Timothy S. Fuerst. 2005. “Oil Prices, Monetary Policy, and the Macroeconomy,” Federal Reserve Bank of Cleveland, 
Policy Discussion Paper, no. 10.Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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material to the editor.
Charles T. Carlstrom is a senior economic
advisor at the Federal Reserve Bank of
Cleveland, and Timothy S. Fuerst is Owens
Illinois Professor of Economics at Bowling
Green State University and a research 
associate at the Federal Reserve Bank 
of Cleveland. 
The views expressed here are those of the
authors and not necessarily those of the Fed-
eral Reserve Bank of Cleveland, the Board of 
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its staff. 
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■ Recommended Reading
Ben S. Bernanke, Mark Gertler, and
Mark Watson. 1997. “Systematic 
Monetary Policy and the Effects of Oil
Price Shocks.” Brookings Papers on
Economic Activity 1, 91–142. 
Ben S. Bernanke, Mark Gertler, and
Mark Watson. 2004. “Oil Shocks and
Aggregate Macroeconomic Behavior:
The Role of Monetary Policy: A Reply,”
Journal of Money, Credit, and Banking,
vol. 36, no. 2, 287–91.
Charles T. Carlstrom and Timothy S.
Fuerst. 2005. “Oil Prices, Monetary 
Policy, and the Macroeconomy,” Federal
Reserve Bank of Cleveland, Policy 
Discussion Paper, no. 10.
Owen F. Humpage and Eduard Pelz.
2003. “Do Energy Spikes Cause Infla-
tion?” Federal Reserve Bank of Cleve-
land, Economic Commentary, April 1.

Oil prices, monetary policy, and the macroeconomy

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Oil prices, monetary policy, and the macroeconomy

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