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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.
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