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Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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May 11, 2006

Oil Or Money?

This comes from David Wessel, in today's Wall Street Journal (page A3 in the print edition):

So far, the global economy and the U.S. economy, in particular, are shrugging off higher oil prices. The latest forecasts, most of which assume oil prices will fall a bit from current levels, predict reasonably strong economic growth for the rest of the year...

But a lot turns on the response of the U.S. Federal Reserve and other central banks. History demonstrates that a sharp increase in oil prices is economically toxic when accompanied by a sharp increase in short-term interest rates. Fed Chairman Ben Bernanke knows his history and vows to avoid repeating it.

Below is a picture I (and many others) have shown before.  The arrows represent episodes in which the relative price of energy -- the energy component of the consumer price index divided by the price index for all other goods and services -- increased by at least 10%.  The shaded bars represent NBER recession dates.




Here is a similar picture, with the federal funds rate substituted for the energy price series.  (The arrows are preserved for reference):




Hmmm.  Sure enough, every energy-price spike has a downturn in the economy in the near temporal vicinity.  But every energy-price spike is likewise associated with a run up in the funds rate. 

Should we be worried?  Wessel continues:

"The crucial difference from the 1970s, in my view, is that today, inflation expectations are low and stable," Mr. Bernanke said. "As a result, the Fed has not had to raise interest rates sharply as it did in the 1970s." The key to keeping inflation expectations "benign," he argued, has been "Fed policies that have kept actual inflation low in recent years, clear communication of those policies, and an institutional commitment to price stability."

That does leave the 1990-91 and 2001 episodes sort of hanging there.  Nevertheless:

So if we all believe higher oil prices won't spark inflation, the Fed won't have to raise interest rates so much to squelch inflation. If the Fed doesn't raise rates too much, the slow-motion supply shock won't provoke a slow-motion recession. Let's hope.


May 11, 2006 in Energy , Federal Reserve and Monetary Policy | Permalink


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Shouldn't higher energy costs result in wage pressures? It seems to me that most of America, especially that part that commutes, is currently beating a path to the boss' office looking for a little bit more in the paycheck. Higher wages will cause inflation. This necessitates the Fed to continue duing their completely irrelevant job of raising interest rates which, while it shouldn't, seems to cause energy prices to rise.

I guess I'm just as dumb as a dog on the darkest night but I can't figure out how continuing to raise interest rates a quarter point at a time will make anything better.

I think they needed to raise one final time yesterday to 6% even. That would have made a real difference and, guess what, the world would keep turning on its axis, the dollar would be stronger today, commodities would begin to descend and, in a couple of weeks, or so stocks would have returned to buy levels.

But that's me - a realist in a Republican-run fantasy world.

Posted by: john | May 11, 2006 at 06:26 PM

"History demonstrates that a sharp increase in oil prices is economically toxic when accompanied by a sharp increase in short-term interest rates."
Hasn't the Fed reacted in the past BECAUSE evidence suggested if they didn't react the increases would be passed through?
I sure hope we haven't entered a twilight zone where the Fed believes it can micromanage our economy so we will NEVER undergo another recession. Recessions are as necessary to our economic well-being as checks & balances are to binding Presidential aspirations to democratic ideals. Oops, maybe that's a bad analogy.

Posted by: bailey | May 12, 2006 at 11:08 AM

The other side of the coin is that oil prices always continue to rise until a recession causes a drop in demand -- the lead time to bring on new supply is so long that it is never in time to impact the supply-demand balance.

In addition even though the Fed knows the lags on monetary policy are long and varied, they virtually always continue to tighten until they see the impact of the tightening in the data. The exception was the early 1990s round. But isn't that what they are doing now?

Posted by: spencer | May 13, 2006 at 11:42 AM

I am curious why bailey thinks that recessions are necessary. I agree that they happen, but theoretically I don't agree that they are necessary.

It is possible to have periods of faster and slower growth with out a recession isn't it?

I think that the key thing the fed is trying to do is maintain level growth, fight inflation, and maintain price stability. (which could be interpreted as the same thing fighting inflation.)

Posted by: jeff | May 13, 2006 at 12:05 PM

Probably because I'm an old man & believe we constantly underprice, then overprice goods - TOO MUCH. Eventually, we seem to revert to the mean. If housing prices in Krugman's "zones" (60% all home on value) weren't SO overpriced I'd agree with you, but my guess is it would take 20 years OR MORE for earnings to increase to the level needed to support current home prices in the "zones". To make matters worse, homeowners have borrowed from their home equity to maintain a lifestyle they can NOT afford. So, the greater problem we face is, the 70% of our population who are lucky enough to own homes, save nothing & have next to nothing set aside for retirement. I wish there was a way around it, but sooner or later, we must stop passing the bill to the next guy and pay it.
It's the Fed's job to see our economy doesn't get so far out of control that we can't afford the interest on the bill or that no one wants us to pay it back in our dollars. (Personally, I'd like to see BB & Co. focus now on increasing 10 yr. yields & unwinding our derivatives market rather then increasing FF further. But, thanks to AG, BB's in a real tough spot.) Clearly, he's heading in the right direction & he deserves our support. If we're going to stop passing the bubble forward from equity mkts. to housing markets to other mkts. we're going to HAVE to slow our economy down & start paying our bills. Unfortunately, for your hope of a soft landing, our consumer's responsible for 2/3 of our GDP.

Posted by: bailey | May 13, 2006 at 02:57 PM

But, if the Fed did not respond aggressively to lower rates from Dec 1999 to 2004, the economy tanks. Remember how they got so low. There was a liquidity crisis on all notes expiring in Dec of 1999. Fear of the Millenium. (I have a friend that is still long powdered milk and velveeta!) Then, in 2001, the terrorist attacks. Meanwhile, China begins developing. They need a place to park dollars and do it in our treasury market.

We had artificially low rates. Even when the Fed went on the course to raise rates, long term rates did not move. Too much buying pressure.

I think a lot of the game of flipping is over in the hot markets. I dont' think Real Estate values are overvalued. Besides native home ownership, we had a lot of foreign buying, especially in Florida.

I have a more optimistic view on the American economy than you do I think.

Posted by: jeff | May 13, 2006 at 06:11 PM

Jeff, you're not alone.
"Raphael Bostic, a real estate analyst at the University of Southern California said it's too early to say that things are looking particularly bad for the housing market. Despite the drop in sales, the large number of listed homes and the recent drop in prices, Bostic said analysts are still watching to see whether prices actually go into freefall.
Bostic doesn't see any reason why that should happen. Traditionally, homes in Southern California have only suffered from extended and significant drops in value as the result of factors largely external to the housing market. The most often-cited example is the last real estate slowdown in the early 1990s, which experts agree was largely caused by massive job losses." Pulled from: http://www.voiceofsandiego.org/site/apps/nl/content2.asp?c=euLTJbMUKvH&b=486837&ct=2453669
Personally, I'm leaning with Shiller, Buffett & common sense.

Posted by: bailey | May 16, 2006 at 11:32 AM

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