speeches · March 1, 2007

Speech

William Poole · President

Energy Prices and the U.S. Business Cycle GlobalInterdependenceCenter(GIC)AbroadinChileConference AmericanChamberofCommerceinChileBreakfast Santiago,Chile March2,2007 Astaple of the macroeconomics litera- deflatedbytheCPIsoastobeinconstant1982-84 ture is that energy price shocks have dollars)since1970.ShadedregionsdenoteU.S. been an important contributor to recessions,asdesignatedbytheNationalBureau U.S. recessions. The situation is ofEconomicResearch.Theseincludetherecession clearly more complicated than the common of1973-75,associatedwiththeoilpriceshockof macro textbookexerciseofusingstandarddia- 1973-74,therecessionsof1980and1981-82, gramstowork out the effects of an energy precededbythesecondoilshockin1979,and shock. Recent experiencewithaneartriplingof therecessionof1990-91,alsoassociatedwitha oilpricesfrommid-2003 to mid-2006 without a large,butmoretransitory,oilpriceincreaseof recession suggests the need to review the con- about75percentin1990-91.Therearealsomore ventional wisdom. Oneofmymessageswillbe drawn-outbutsteepoilincreasesin1999-2000 thattheconventional wisdomfailstoconsider and2003-2006.Thepresenceoftherecession thefactthatpreviousoil price shocks occurred barsinthegraphbringsoutwhatHamiltonand when the U.S. economy was already suffering Herrera(2004,p.265)observeis“acorrelation from substantial inflation pressures,whereasthe betweenincreasesinoilpricesandsubsequent recentrun-upofoilprices has occurred in an economicdownturns.”Inparticular,recessions economy with substantial overall price stability beganintheUnitedStateswithinayearofthe and entrenched, low inflation expectations. 1973,1979,and1990oilpriceincreases. BeforeIdigintotheissueoftheextentof Therehasbeenmuchdebateonhowmuch causalitybetweenoilpriceshocksandrecessions, ofthislinkbetweenrecessionsandprioroilprice IwanttoemphasizethattheviewsIexpresshere increasesshouldbeattributedtothepowerful aremineanddonotnecessarilyreflectofficial effectofoilshocksontheeconomy,andhow positionsoftheFederalReserveSystem.Ithank muchreflectsathirdfactor—morerestrictive mycolleaguesattheFederalReserveBankofSt. monetarypolicyimposedatroughlythesame Louisfortheircomments.EdNelson,assistant timeastheoilshocks.ButIwoulddrawattention vicepresident,providedspecialassistance.I toanotheraspectoftherelationshipbetweenthe retainfullresponsibilityforerrors. businesscycleandoilpriceshighlightedbythe figure.TheUnitedStateshasneverhadanenergy pricespikeoccurinthemiddleofarecession,or THE DEBATE immediatelyfollowingarecessionwhenunem- Thehistoricalrecordsince1970provides ploymentisstillrelativelyhigh.Thisfactsuggests someperspectiveontherelationshipbetween twopropertiesoflargeoilpriceincreasesthat oilpricesandthebusinesscycle.Figure1plots areusefultokeepinmind.First,verysharp theU.S.benchmarkoilprice(theWestTexas increasesinoilpricesthatwehaveobservedhis- intermediatespotprice),bothinnominalterms torically,whileundoubtedlyreflectingexogenous (i.e.,currentU.S.dollars)andrealterms(i.e., supplydisruptionstosomedegree,alsoreflect 1 ECONOMICFLUCTUATIONS Figure 1 Oil Prices and the Business Cycle $/Barrel 1982$/Barrel 80.0 60.0 70.0 Nominal Dollar Oil Price(left axis) 50.0 Real Oil Price(1982-84Dollars) (right axis) 60.0 40.0 50.0 40.0 30.0 30.0 20.0 20.0 10.0 10.0 0.0 0.0 1970 1975 1980 1985 1990 1995 2000 2005 NOTE:ShadedareasareNBERrecessions. thestrengthoftheeconomyatthetime.Secondly, 8.1percentona12-monthbasis,asharprisefrom thecasualassociationoftenmade,basedonthe the3.2percentrateoverthe12monthsendingin 1970sexperience,betweenoilpriceincreases October1972.AnnualCPIinflationsubsequently andhighinflation,islargelymisguidedbecause roseto11.8percentinOctober1974andpeaked thelargeoilpriceincreasesofthe1970soccurred at12.2percentinNovember1974. againstthebackgroundofcyclicalexpansions Similarly,inthewakeofseveralyearsof thathadgonetoofar. expandingdemand,inflationrosethroughout The1973and1979episodesdidnotfeature mostof1977and1978,wellbeforethesecond inflationaryspiralstriggeredbytheoilshocks. oilshock,andthe12-monthratestoodat9.3per- Instead,theyarecharacterizedbypreexisting, centinJanuary1979,2.5percentagepointsabove generalinflationarypressuresthatanalternative itsvalueofJanuary1978.Inflationsubsequently monetarypolicycouldhaveavoided.Thefirst peakedat14.6percentinMarch1980.Eventhe oilshockin1973occurredagainstabackground 1990oilpricespikeoccurredlateinalongeco- ofcleareconomicoverheatingintheUnitedStates. nomicexpansion,withannualinflationhaving U.S.monetarypolicywasveryexpansionaryin stoodabove4percentsincemid-1988.InJuly 1971and1972,leadingtoexcessivegrowthof 1990,the12-monthCPIinflationratewas4.8 aggregatedemandthat,eveninthepresenceof percent,toohightocorrespondtopricestability pricecontrols,spilledoverintorisinginflation andnotfarbelowtheJuly1989valueof5.1per- in1973.ByOctober1973—thatis,themonthof cent.FollowingtheoilshockthatbeganinAugust thefirstoilshock,butlargelybeforeitsimpact 1990,inflationpeakedat6.4percentinOctober couldbefeltintheCPI—inflationhadreached 1990. 2 EnergyPricesandtheU.S.BusinessCycle Thestrengthoftheeconomyatthetimeof OIL PRICES AND INFLATION thethreeoilshocksisalsoreflectedintheunem- MembersoftheFOMC,aswellasmonetary ploymentrate.InOctober1973,theseasonally policymakersinEuropeandtheUnitedKingdom, adjustedU.S.unemploymentratestoodat4.6 havespokenaboutoilpricesandinflationon percent,itslowestratesinceearly1970;inJanuary manyoccasionsinrecentyears.Despitediffer- 1979itwas5.9percent,closetoitstroughfor encesinemphasis,aclearpropositionruns thelate1970sexpansion;andinJuly1990, throughthesediscussions:Irrespectiveofthe unemploymentwas5.5percent,aboveitsMarch behaviorofoilprices,wecanbeconfidentthat 1989lowof5.0percent,butstilllowerthanits monetarypolicyorientedtopricestabilitywill valueinanymonthintheyears1975to1987. delivercontroloverinflationoverthemedium Thisemphasisonthelinkbetweenthestate term.Itisworthspellingoutthispropositionin ofthebusinesscycleandthestrengthofoilprices somedetail. mayseemsurprising.Manyofthewell-known Thereasonwhypricestabilityisnotcontin- spikesintheoilpriceareassociatedwithexoge- gentonoilpricebehavioristhatinflationisa nouseventsonthesupplyside:forexample, sustainedriseinthegenerallevelofprices.The OPEC’squadruplingoftheoilpriceinlate1973 priceofoilentersheavilyintoaparticularcate- inthewakeoftheMiddleEastwar;OPEC’sdou- goryofconsumerprices—gasolineprices—and blingoftheoilpricein1979followingtherevo- indirectlyintothepricesofmanyotherproducts. lutioninIran;andIraq’sinvasionofKuwaitin Itispossibleforthepriceofenergy-intensive 1990.Theseeventswerecertainlymajorsupply- goodstochangerelativetoageneralindexof sidedisruptions.ButevenacartellikeOPECthat prices;infact,suchrelative-pricemovements administersthepriceofitsproductcannotignore arepartoftheeverydayworkingsofamarket marketconditions.Inparticular,areasonwhy economy.And,overperiodsof,say,ayearor moreitispossibleformonetarypolicytosecure OPECwasabletosustaintheverylarge1973oil lowinflation—whichmeanslowgrowthratesin priceincreaseforsolongwasbecauseworld indexesofoverallprices—evenwhenenergyprice demandforoilwasunderpinnedbyrapidexpan- inflationishigh.Overtime,thegenerallevelof sionofaggregatedemandinkeymarketsin pricesrespondstothesupply-demandimbalance Europe,JapanandtheUnitedStates.Indeed, intheeconomy:thatis,tolonger-termmovement someanalystsofthe1973oilshockhavecast intotalspendingintheeconomyrelativetolong- doubtonwhethertheoilpriceincreaseof1973 runsupplypotential.Monetarypolicyactions canbeconsideredanexogenouseventatall; affectthetotalvolumeofspending,andsocan BarskyandKilian(2001)arguethatitwasa influencethebalancebetweenaggregatedemand delayedresponsetolong-termdemanddevelop- andsupply.Bykeepingaggregatedemandinbal- mentsintheoilmarket,combinedwitharesponse ancewithaggregatesupply,monetarypolicycan tocontemporaneousbuoyantworlddemandcon- createconditionsforgeneralpricestability,even ditions.1Wedonothavetogothisfar,however, ifcertaincomponentsinthepriceindexareper- torecognizethattherewasasignificantendoge- sistentlyincreasing. nouscomponenttotheoilpriceincreasesin Twoaspectsofthispictureareworthempha- 1973and1979duetodemandfactors,reflecting sizing.First,theoverallpricelevelissusceptible anoverheatingoftheU.S.economywhichcoin- toinfluencebymonetarypolicyeveniftheprice cidedwithboomconditionsinotheradvanced ofoil,orothercommodities,isbeingdrivenby economies. exogenoussupplyevents.ThatiswhyMilton 1 SeeHamilton(2003,pp.388-89)forarebuttalofBarskyandKilian’s(2001)positionthatthe1973-74oilpriceincreasedidnotincorporatea majorexogenoussupplyshift. 3 ECONOMICFLUCTUATIONS Friedmancouldadvancehispropositionthat so,somereininginofspendingbymonetary “inflationisalwaysandeverywhereamonetary policywasjustifiedevenbeforetheoilshock; phenomenon”eventhoughheacknowledged butoncetheoilshocktookplace,monetary thatthe1973OPECshockhadproduceda“dras- policyneededtotighten,justtokeepsupplyand ticalterationintheconditionsofsupplyofcrude demandfromgoingfurtherintoimbalance.That oil.”2Thegeneraltrendofpricesisdistinctfrom is,itwasnecessarytoletactualoutputfallwith thebehaviorofasinglepriceintheindexorsub- thedeclineinpotentialoutput.Fromthisper- setoftheindex.Inflationisalwaysanendoge- spective,HamiltonandHerrera(2004)arenot nousvariableinthemediumterm,whatever necessarilyposingtherightquestionwhenthey exogenousshocksareaffectingitscomponents askhowmuchofamonetarypolicyloosening intheshortterm. wouldhavebeenrequiredtoavoidarecession Secondly,monetarypolicymakersoftenpay afterthe1973oilshock.Thesupplyshockalone attentionto“core”measuresofpricesthatexclude justifiedamonetarypolicytighteningonstabi- energyandfoodprices.Thisfocusdoesnot,how- lizationgrounds. ever,meanthatpolicymakers’conceptofprice Inrecentyears,ontheotherhand,thecir- stabilityrefersonlytoabasketofgoodsthat cumstancesofthe1973oilshockhavenotbeen excludesenergy-intensiveitems.Theoverall repeated.Theeconomyhasnotbeenoverheated; costoflivingiswhatmattersforwelfare,sosta- theeconomyismoreenergy-efficientsotheimpact bilityovertimeinindexesthatincludeenergy onsupplyofoilshockshasbeenmoderated;and isdesirable.Butbecausethepriceofgasolineis themoreseverespikesintheoilpricesuchasin volatile,itisoftendesirableto“seethrough” summer2006havebeenrecognizedastransitory veryshort-termmovementsinconsumerprices, innature.Inthesecircumstances,monetarypol- andworkoutwhatishappeningtotheunderly- icyisinamuchbetterpositiontosupportaggre- ingtrendofprices.Lookingatcoremeasuresof gatedemandinthefaceofoilshockswithout inflationcanbeusefulforthispurpose.Indeed endangeringmedium-termpricestability.This coreandaggregateinflationclearlymovetogether stateofaffairshasbeenemphasizedbytheFederal overlongerperiods.Thatsaid,duringperiodsof ReserveChairmaninhisdiscussionoftheeffect sustainedincreasesinrelativeenergyprices, ofoilshocks(Bernanke,2006). generalpricestabilityrequiresthatpriceindexes Insummary,maintenanceoflowinflation thatexcludeenergywillneedtogrowmoreslowly overaperiodofseveralyearsormoreisachiev- thantheaggregatepriceindex;overthisperiod, ablewhateverhappenstooilprices.Thesame achievementofinflationatadesirablelevelmeans wastrueinthe1970s,andthefactthatinflation thatcoreinflation,onaverage,proceedsbelow washighonaveragereflectedover-expansionary theoveralllevelofinflation. monetarypolicy,nottheoilshocks. Thirdly,anoilpriceincreasemayreduce aggregatesupplyandpolicymakersalsoneedto takethisfactintoaccountinkeepingdemand RECENT OIL PRICE INCREASES andsupplyinbalance.Thisissueismostpromi- nentwhentheoilpricechangeispermanentand Theoilpriceincreasein2003-2006isinline whentheeconomy’stechnologyisveryenergy- withtheearlierpatternthatsurgesinoilprices intensiveonaverage.The1973oilshock,for occurduringeconomicexpansions.Indeed, example,waslong-lastingandtookplaceata recentincreasesaremoreclearlyademandphe- timewhenU.S.productionwasveryenergy- nomenonthanthepreviousincreases.Energy inefficient.Potentialoutputthusfellsubstantially. pricesinrecentyearshavebeendrivenbydemand Theeconomywasalreadyoverheatedby1973; ratherthansupply.Thesourceofthisdemandis 2 FriedmanandSchwartz(1982,p.414). 4 EnergyPricesandtheU.S.BusinessCycle unusualcomparedtothepast,withasmaller wholightsthematchorthepersonwhoopened contributionofU.S.demandandamuchlarger thejets?IknowwhereIwanttoplacetheblame. contributionofChina.China’snetimportsofoil wereprojectedtobe2.3percentofitsGDPin 2006comparedto0.9percentin2002(IMF,2006, REFERENCES p.31).Alonger-termperspectiveisgivenbythe Barsky,RobertB.andKilian,Lutz.“DoWeReally factthatChina'sshareofworlddemandforoilis KnowThatOilCausedtheGreatStagflation?A estimatedtohaverisenfrom3.5percentin1990 MonetaryAlternative.”NBERMacroeconomics toaround8.2percentin2006(Weber,2006).This Annual,2001,16(1),pp.137-83. increasereflectstherapidgrowthandindustrial- izationofChinainthepastfifteenyears,aswell Bernanke,BenS.“EnergyandtheEconomy.” astheuseofproductiontechnologythatis,on RemarksbeforetheEconomicClubofChicago, average,energy-inefficientcomparedtothe Chicago,Illinois,June15,2006. UnitedStates. Friedman,Milton,andSchwartz,AnnaJ.Monetary TrendsintheUnitedStatesandtheUnitedKingdom. CONCLUSIONS Chicago:UniversityofChicagoPress,1982. Withoutquestion,energysupplyshocksare Hamilton,JamesD.“WhatIsanOilShock?”Journal disruptive,buttheyneednotcreaterecessions. ofEconometrics,2003,113(2),pp.363-98. Indeed,thereisamoregenerallessonfromexpe- riencewithoilpriceshocks.Monetarypolicy Hamilton,JamesD.andHerrera,AnaMaria.“Oil shouldnotallowaneconomytooperateatthe ShocksandAggregateMacroeconomicBehavior: edgeofacliff.Whenbalancedprecariouslyat TheRoleofMonetaryPolicy.”JournalofMoney, theedgeofacliff,evenaminordisturbance,oil CreditandBanking,2004,36(2),pp.265-86. orotherwise,maybesufficienttopushtheecon- omyovertheedge.Althoughanoutsideshock InternationalMonetaryFund.People’sRepublicof maybethecatalyst,ortrigger,thatcreatesundue China—ArticleIVConsultation:StaffReport. inflationpressures,thefundamentalproblemis Washington,DC,2006. notthecatalystbutthepowerfulandriskybrew ofanoverheatedeconomy.Touseanotheranalogy, Weber,AxelA.“OilPriceShocksandMonetary ifsomeoneopensgasjetsandfillsahousewith PolicyintheEuroArea.”WhitakerLectureby PresidentoftheDeutscheBundesbank,2006. gas,doweblametheexplosionontheperson 5

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APA

William Poole (2007, March 1). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20070302_poole

BibTeX

@misc{wtfs_speech_20070302_poole,
  author = {William Poole},
  title = {Speech},
  year = {2007},
  month = {Mar},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20070302_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}