TCS Daily

Oil Prices and the Federal Reserve

By Desmond Lachman - September 3, 2004 12:00 AM

The recent spike in international oil prices towards $50 a barrel has conjured up distant memories of earlier oil price shocks. In some quarters it has also raised calls for the Federal Reserve to speed up its planned return to more normal interest rates for fear of allowing inflation again to rear its ugly head. Before heeding such advice, the Federal Reserve would do well to examine how the present run up in international oil prices differs from previous such episodes. For such an examination might reveal that raising interest rates now would be a costly mistake.

Among the clearer monetary policy lessons learnt from the oil price shocks of the 1970s and 1980s was that monetary policy should not accommodate with low interest rates the second round impact of such shocks. Indeed, we have painfully learnt that if the Federal Reserve accommodates an oil price shock, the resulting increase in inflation tends to get incorporated into inflationary expectations. This makes inflation more persistent and it significantly raises the eventual cost of wringing inflation out of the economy.

While the Federal Reserve should certainly not repeat past mistakes of accommodating oil price shocks, it should be careful to calibrate its monetary policy response to the particular circumstances of any future such shock. In responding to the present oil price shock, the Federal Reserve should take into account the relative size of that shock, its likely duration, and the more general macro-economic context within which it is occurring.

A distinguishing characteristic of the present oil price shock is that it is small by the standards of earlier such shocks. On the basis of IMF estimates, even were oil prices to remain at US$45 a barrel, the direct impact of the current oil price shock on the net trade balances of the advanced industrial countries would amount to barely ½ a percentage point of GDP. This would pale in comparison to the oil price shocks of 1973-74 and of 1979-80 that had net direct trade impacts of 2 ½ percentage points and 3 ¾ percentage points of GDP, respectively.

The relatively small size of the present oil price shock reflects in part the cumulative price inflation since the 1970s. However, it also reflects the very much lower intensity now than in previous decades of oil use by the industrialized economies.

While the latest oil price shock appears relatively small at present, it is too early for the Federal Reserve to know how much further this oil price increase might go and for how long it might last. However, it would appear imprudent for the Federal Reserve to presume either that the shock will worsen or that it will last for very long. For the present run up in oil prices would seem to be less about shifts in fundamental balances of demand and supply than about market fears about political developments in the Middle East, Nigeria, Russia, and Venezuela. Should those fears prove to be misplaced, oil prices could very well rapidly retrace their earlier run up.

An even more compelling reason for the Federal Reserve to be cautious in responding to the present oil price shock is the weak general macro-economic environment within which that shock is occurring. Second quarter data indicate that, even prior to the shock, the US economy had slowed to a rate of growth below its long run potential. Since then the economy has been experiencing a soft patch, while core price inflation has resumed its deceleration to around 1 ½ percent or to well within the Federal Reserve's comfort zone.

In the remainder of 2004, not only will the economy have to withstand higher oil prices, it will have to cope with the fading of the earlier tax refunds and the raising of interest rates. In those circumstances, and with core inflation well contained, prudence would suggest that the Federal Reserve pause in returning interest rates to more neutral levels. This would appear to be a very much less risky course of action than reacting in a knee jerk fashion to higher oil prices by raising interest rates, which could further slow an already weakening and non-inflationary economy.

The author is Resident Fellow, American Enterprise Institute and a TCS contributor.


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