A speech at the Global Interdependence Center Abroad in Chile Conference, American Chamber of Commerce in Chile Breakfast, Santiago, Chile, March 2, 2007Power resources - Prices ; Business cycles

William Poole

English

Research Papers in Economics

1
Energy Prices and the U.S. Business Cycle
Global Interdependence Center (GIC) Abroad in Chile Conference
American Chamber of Commerce in Chile Breakfast
Santiago, Chile
March 2, 2007
deflated by the CPI so as to be in constant 1982-84
dollars) since 1970. Shaded regions denote U.S.
recessions, as designated by the National Bureau
of Economic Research. These include the recession
of 1973-75, associated with the oil price shock of
1973-74, the recessions of 1980 and 1981-82,
preceded by the second oil shock in 1979, and
the recession of 1990-91, also associated with a
large, but more transitory, oil price increase of
about 75 percent in 1990-91. There are also more
drawn-out but steep oil increases in 1999-2000
and 2003-2006. The presence of the recession
bars in the graph brings out what Hamilton and
Herrera (2004, p. 265) observe is “a correlation
between increases in oil prices and subsequent
economic downturns.” In particular, recessions
began in the United States within a year of the
1973, 1979, and 1990 oil price increases.
There has been much debate on how much
of this link between recessions and prior oil price
increases should be attributed to the powerful
effect of oil shocks on the economy, and how
much reflects a third factor—more restrictive
monetary policy imposed at roughly the same
time as the oil shocks. But I would draw attention
to another aspect of the relationship between the
business cycle and oil prices highlighted by the
figure. The United States has never had an energy
price spike occur in the middle of a recession, or
immediately following a recession when unem-
ployment is still relatively high. This fact suggests
two properties of large oil price increases that
are useful to keep in mind. First, very sharp
increases in oil prices that we have observed his-
torically, while undoubtedly reflecting exogenous
supply disruptions to some degree, also reflect
A
staple of the macroeconomics litera-
ture is that energy price shocks have
been an important contributor to
U.S. recessions. The situation is
clearly more complicated than the common
macro textbook exercise of using standard dia-
grams to work out the effects of an energy
shock. Recent experience with a near tripling of
oil prices from mid-2003 to mid-2006 without a
recession suggests the need to review the con-
ventional wisdom. One of my messages will be
that the conventional wisdom fails to consider
the fact that previous oil price shocks occurred
when the U.S. economy was already suffering
from substantial inflation pressures, whereas the
recent run-up of oil prices has occurred in an
economy with substantial overall price stability
and entrenched, low inflation expectations.
Before I dig into the issue of the extent of
causality between oil price shocks and recessions,
I want to emphasize that the views I express here
are mine and do not necessarily reflect official
positions of the Federal Reserve System. I thank
my colleagues at the Federal Reserve Bank of St.
Louis for their comments. Ed Nelson, assistant
vice president, provided special assistance. I
retain full responsibility for errors.
THE DEBATE
The historical record since 1970 provides
some perspective on the relationship between
oil prices and the business cycle. Figure 1 plots
the U.S. benchmark oil price (the West Texas
intermediate spot price), both in nominal terms
(i.e., current U.S. dollars) and real terms (i.e.,the strength of the economy at the time. Secondly,
the casual association often made, based on the
1970s experience, between oil price increases
and high inflation, is largely misguided because
the large oil price increases of the 1970s occurred
against the background of cyclical expansions
that had gone too far.
The 1973 and 1979 episodes did not feature
inflationary spirals triggered by the oil shocks.
Instead, they are characterized by preexisting,
general inflationary pressures that an alternative
monetary policy could have avoided. The first
oil shock in 1973 occurred against a background
of clear economic overheating in the United States.
U.S. monetary policy was very expansionary in
1971 and 1972, leading to excessive growth of
aggregate demand that, even in the presence of
price controls, spilled over into rising inflation
in 1973. By October 1973—that is, the month of
the first oil shock, but largely before its impact
could be felt in the CPI—inflation had reached
8.1 percent on a 12-month basis, a sharp rise from
the 3.2 percent rate over the 12 months ending in
October 1972. Annual CPI inflation subsequently
rose to 11.8 percent in October 1974 and peaked
at 12.2 percent in November 1974.
Similarly, in the wake of several years of
expanding demand, inflation rose throughout
most of 1977 and 1978, well before the second
oil shock, and the 12-month rate stood at 9.3 per-
cent in January 1979, 2.5 percentage points above
its value of January 1978. Inflation subsequently
peaked at 14.6 percent in March 1980. Even the
1990 oil price spike occurred late in a long eco-
nomic expansion, with annual inflation having
stood above 4 percent since mid-1988. In July
1990, the 12-month CPI inflation rate was 4.8
percent, too high to correspond to price stability
and not far below the July 1989 value of 5.1 per-
cent. Following the oil shock that began in August
1990, inflation peaked at 6.4 percent in October
1990.
ECONOMIC FLUCTUATIONS
2
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
0.0
10.0
20.0
30.0
40.0
50.0
60.0
$/Barrel 1982 $/Barrel
Nominal Dollar Oil Price (left axis)
Real Oil Price (1982-84 Dollars) (right axis)
1970 1975 1980 1985 1990 1995 2000 2005
Figure 1
Oil Prices and the Business Cycle
NOTE: Shaded areas are NBER recessions.The strength of the economy at the time of
the three oil shocks is also reflected in the unem-
ployment rate. In October 1973, the seasonally
adjusted U.S. unemployment rate stood at 4.6
percent, its lowest rate since early 1970; in January
1979 it was 5.9 percent, close to its trough for
the late 1970s expansion; and in July 1990,
unemployment was 5.5 percent, above its March
1989 low of 5.0 percent, but still lower than its
value in any month in the years 1975 to 1987.
This emphasis on the link between the state
of the business cycle and the strength of oil prices
may seem surprising. Many of the well-known
spikes in the oil price are associated with exoge-
nous events on the supply side: for example,
OPEC’s quadrupling of the oil price in late 1973
in the wake of the Middle East war; OPEC’s dou-
bling of the oil price in 1979 following the revo-
lution in Iran; and Iraq’s invasion of Kuwait in
1990. These events were certainly major supply-
side disruptions. But even a cartel like OPEC that
administers the price of its product cannot ignore
market conditions. In particular, a reason why
OPEC was able to sustain the very large 1973 oil
price increase for so long was because world
demand for oil was underpinned by rapid expan-
sion of aggregate demand in key markets in
Europe, Japan and the United States. Indeed,
some analysts of the 1973 oil shock have cast
doubt on whether the oil price increase of 1973
can be considered an exogenous event at all;
Barsky and Kilian (2001) argue that it was a
delayed response to long-term demand develop-
ments in the oil market, combined with a response
to contemporaneous buoyant world demand con-
ditions.1 We do not have to go this far, however,
to recognize that there was a significant endoge-
nous component to the oil price increases in
1973 and 1979 due to demand factors, reflecting
an overheating of the U.S. economy which coin-
cided with boom conditions in other advanced
economies.
OIL PRICES AND INFLATION
Members of the FOMC, as well as monetary
policy makers in Europe and the United Kingdom,
have spoken about oil prices and inflation on
many occasions in recent years. Despite differ-
ences in emphasis, a clear proposition runs
through these discussions: Irrespective of the
behavior of oil prices, we can be confident that
monetary policy oriented to price stability will
deliver control over inflation over the medium
term. It is worth spelling out this proposition in
some detail.
The reason why price stability is not contin-
gent on oil price behavior is that inflation is a
sustained rise in the general level of prices. The
price of oil enters heavily into a particular cate-
gory of consumer prices—gasoline prices—and
indirectly into the prices of many other products.
It is possible for the price of energy-intensive
goods to change relative to a general index of
prices; in fact, such relative-price movements
are part of the everyday workings of a market
economy. And, over periods of, say, a year or
more it is possible for monetary policy to secure
low inflation—which means low growth rates in
indexes of overall prices—even when energy price
inflation is high. Over time, the general level of
prices responds to the supply-demand imbalance
in the economy: that is, to longer-term movement
in total spending in the economy relative to long-
run supply potential. Monetary policy actions
affect the total volume of spending, and so can
influence the balance between aggregate demand
and supply. By keeping aggregate demand in bal-
ance with aggregate supply, monetary policy can
create conditions for general price stability, even
if certain components in the price index are per-
sistently increasing.
Two aspects of this picture are worth empha-
sizing. First, the overall price level is susceptible
to influence by monetary policy even if the price
of oil, or other commodities, is being driven by
exogenous supply events. That is why Milton
Energy Prices and the U.S. Business Cycle
3
1 See Hamilton (2003, pp. 388-89) for a rebuttal of Barsky and Kilian’s (2001) position that the 1973-74 oil price increase did not incorporate a
major exogenous supply shift.Friedman could advance his proposition that
“inflation is always and everywhere a monetary
phenomenon” even though he acknowledged
that the 1973 OPEC shock had produced a “dras-
tic alteration in the conditions of supply of crude
oil.”2 The general trend of prices is distinct from
the behavior of a single price in the index or sub-
set of the index. Inflation is always an endoge-
nous variable in the medium term, whatever
exogenous shocks are affecting its components
in the short term.
Secondly, monetary policymakers often pay
attention to “core” measures of prices that exclude
energy and food prices. This focus does not, how-
ever, mean that policymakers’ concept of price
stability refers only to a basket of goods that
excludes energy-intensive items. The overall
cost of living is what matters for welfare, so sta-
bility over time in indexes that include energy
is desirable. But because the price of gasoline is
volatile, it is often desirable to “see through”
very short-term movements in consumer prices,
and work out what is happening to the underly-
ing trend of prices. Looking at core measures of
inflation can be useful for this purpose. Indeed
core and aggregate inflation clearly move together
over longer periods. That said, during periods of
sustained increases in relative energy prices,
general price stability requires that price indexes
that exclude energy will need to grow more slowly
than the aggregate price index; over this period,
achievement of inflation at a desirable level means
that core inflation, on average, proceeds below
the overall level of inflation.
Thirdly, an oil price increase may reduce
aggregate supply and policymakers also need to
take this fact into account in keeping demand
and supply in balance. This issue is most promi-
nent when the oil price change is permanent and
when the economy’s technology is very energy-
intensive on average. The 1973 oil shock, for
example, was long-lasting and took place at a
time when U.S. production was very energy-
inefficient. Potential output thus fell substantially.
The economy was already overheated by 1973;
so, some reining in of spending by monetary
policy was justified even before the oil shock;
but once the oil shock took place, monetary
policy needed to tighten, just to keep supply and
demand from going further into imbalance. That
is, it was necessary to let actual output fall with
the decline in potential output. From this per-
spective, Hamilton and Herrera (2004) are not
necessarily posing the right question when they
ask how much of a monetary policy loosening
would have been required to avoid a recession
after the 1973 oil shock. The supply shock alone
justified a monetary policy tightening on stabi-
lization grounds.
In recent years, on the other hand, the cir-
cumstances of the 1973 oil shock have not been
repeated. The economy has not been overheated;
the economy is more energy-efficient so the impact
on supply of oil shocks has been moderated; and
the more severe spikes in the oil price such as in
summer 2006 have been recognized as transitory
in nature. In these circumstances, monetary pol-
icy is in a much better position to support aggre-
gate demand in the face of oil shocks without
endangering medium-term price stability. This
state of affairs has been emphasized by the Federal
Reserve Chairman in his discussion of the effect
of oil shocks (Bernanke, 2006).
In summary, maintenance of low inflation
over a period of several years or more is achiev-
able whatever happens to oil prices. The same
was true in the 1970s, and the fact that inflation
was high on average reflected over-expansionary
monetary policy, not the oil shocks.
RECENT OIL PRICE INCREASES
The oil price increase in 2003-2006 is in line
with the earlier pattern that surges in oil prices
occur during economic expansions. Indeed,
recent increases are more clearly a demand phe-
nomenon than the previous increases. Energy
prices in recent years have been driven by demand
rather than supply. The source of this demand is
ECONOMIC FLUCTUATIONS
4
2 Friedman and Schwartz (1982, p. 414).unusual compared to the past, with a smaller
contribution of U.S. demand and a much larger
contribution of China. China’s net imports of oil
were projected to be 2.3 percent of its GDP in
2006 compared to 0.9 percent in 2002 (IMF, 2006,
p. 31). A longer-term perspective is given by the
fact that China's share of world demand for oil is
estimated to have risen from 3.5 percent in 1990
to around 8.2 percent in 2006 (Weber, 2006). This
increase reflects the rapid growth and industrial-
ization of China in the past fifteen years, as well
as the use of production technology that is, on
average, energy-inefficient compared to the
United States.
CONCLUSIONS
Without question, energy supply shocks are
disruptive, but they need not create recessions.
Indeed, there is a more general lesson from expe-
rience with oil price shocks. Monetary policy
should not allow an economy to operate at the
edge of a cliff. When balanced precariously at
the edge of a cliff, even a minor disturbance, oil
or otherwise, may be sufficient to push the econ-
omy over the edge. Although an outside shock
may be the catalyst, or trigger, that creates undue
inflation pressures, the fundamental problem is
not the catalyst but the powerful and risky brew
of an overheated economy. To use another analogy,
if someone opens gas jets and fills a house with
gas, do we blame the explosion on the person
who lights the match or the person who opened
the jets? I know where I want to place the blame.
REFERENCES
Barsky, Robert B. and Kilian, Lutz. “Do We Really
Know That Oil Caused the Great Stagflation? A
Monetary Alternative.” NBER Macroeconomics
Annual, 2001, 16(1), pp. 137-83.
Bernanke, Ben S. “Energy and the Economy.”
Remarks before the Economic Club of Chicago,
Chicago, Illinois, June 15, 2006.
Friedman, Milton, and Schwartz, Anna J. Monetary
Trends in the United States and the United Kingdom.
Chicago: University of Chicago Press, 1982.
Hamilton, James D. “What Is an Oil Shock?” Journal
of Econometrics, 2003, 113(2), pp. 363-98.
Hamilton, James D. and Herrera, Ana Maria. “Oil
Shocks and Aggregate Macroeconomic Behavior:
The Role of Monetary Policy.” Journal of Money,
Credit and Banking, 2004, 36(2), pp. 265-86.
International Monetary Fund. People’s Republic of
China—Article IV Consultation: Staff Report.
Washington, DC, 2006.
Weber, Axel A. “Oil Price Shocks and Monetary
Policy in the Euro Area.” Whitaker Lecture by
President of the Deutsche Bundesbank, 2006.
Energy Prices and the U.S. Business Cycle
5

Do We Really Know That Oil Caused the Great Stagflation? A Monetary Alternative.”

Energy and the Economy.” Remarks before the Economic Club of Chicago,

Oil Price Shocks and Monetary Policy

Oil Shocks and Aggregate Macroeconomic Behavior: The Role of Monetary Policy.”

What Is an Oil Shock?”

Energy prices and the U.S. business cycle

http://fraser.stlouisfed.org/historicaldocs/1103/download/40921/20070302.pdf

Energy prices and the U.S. business cycle

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics