FRBSF Economic Letter
2005-28; October 28, 2005
Oil Price Shocks and Inflation
Oil prices have risen sharply over the last year, leading
to concerns that we could see a repeat of the 1970s, when
rising oil prices were accompanied by severe recessions
and surging inflation. This Economic Letter examines the
historical relationship between oil price shocks and inflation
in light of some recent research and goes on to discuss
what the recent jump in oil prices might mean for inflation
in the future.
The historical record
 Figure 1 plots the price of oil relative
to the core personal consumption expenditures price index
(PCEPI) together with
the core PCEPI inflation rate. (Core measures of inflation
exclude food and energy prices.) The figure shows that
the price of oil jumped sharply twice in the 1970s, as
did inflation. But this relationship appears to have
deteriorated over the latter part of the sample; for example,
when oil
prices fell sharply in the mid-1980s, core inflation
appears to have been unaffected. Similarly, the last part
of our
sample shows a sustained increase in the relative price
of oil that does not appear to be reflected in inflation.
Hooker (2002) provided formal evidence of this change
in the relationship between oil prices and inflation over
the 1962-2000 period. His model used the rate of change
of oil prices, the unemployment gap (which is the prevailing
unemployment rate relative to a benchmark known as the
natural rate of unemployment) and lagged inflation to
predict
core PCE inflation. Statistical tests found a break in
the estimated relationship among these variables at the
end of 1980. When he allowed this relationship to differ
between the periods 1962-1980 and 1981-2000, he found
that oil prices had a significant impact on inflation in
the
earlier period, but not in the later period. This result
did not change when he used other measures of inflation
(specifically, either the core CPI or the chain-weighted
GDP price index), other measures of resource utilization,
or other measures of fuel and energy costs. Changes in
the hypothesized relationship between oil prices and
inflation (such as allowing oil price increases to affect
the economy
differently from oil price decreases) did not matter
either. It is worth noting that Hooker's results--that
is, that
oil price shocks fail to predict inflation over the post-1980
period--also hold even when the sample is extended to
include data through early 2005.
Does this mean that oil shocks
no longer matter for inflation? The answer depends upon
what's behind the observed change
in the relationship. For instance, if Hooker's finding
is the result of a change in the conduct of monetary
policy, then policymakers need to make sure that they do
not respond
as they did in the 1970s. By contrast, if it is the result
of a permanent change in the structure of the economy,
then there is no reason to worry about the effect of
oil prices on inflation anymore. Hooker examined several
kinds
of structural change, including the substantial decline
in the energy intensity of the economy since the 1960s
and deregulation in the energy sector, but found that
these developments did not help explain the change in the
relationship
between oil prices and inflation. The role of monetary policy
To see what role policy might
play, assume that we lived in a world where oil was a
substantial input to the economy
and where a large increase in the price of oil led to
a large increase in costs for a substantial share of firms
in the economy. Even here, the Fed could choose to prevent
these increases from showing up in core prices by a sufficient
tightening of policy. Thus, the finding that oil shocks
no longer have much impact on inflation could reflect
a
much more vigorous response by the Fed to offset the
effects of oil shocks on inflation. Hooker examines this
possibility
by estimating a version of a model constructed by Bernanke,
Gertler, and Watson (1997) to study the interaction between
oil shocks and monetary policy. He finds that the Fed
actually has responded less to oil price shocks since the
beginning
of the 1980s.
While a changed policy response to oil shocks
does not appear to be the explanation, other aspects
of policy have
changed in ways that may help explain what is going on.
As documented by a large number of studies, such as Clarida,
Gali, and Gertler (2000), the Fed now reacts much more
vigorously to changes in inflation than it did during
the 1960s and 1970s. This has led to a marked decline in
core
inflation and inflation volatility since the 1970s. Various
surveys reveal that the decline in inflation has been
accompanied by a decline in inflation expectations; further,
it is
generally agreed that inflation expectations are much
better contained than they were in the 1970s. Fed credibility
appears to be tied to this change in expectations.
Changing
inflation expectations are likely to be part of the reason
why recent oil shocks have not had the same
impact on inflation that they did in the 1970s and could
also explain Hooker's findings on the change in the Fed's
response to oil shocks. It appears that during the 1970s
households and firms did not expect the Fed to act to
offset the inflationary impulse created by a jump in the
price
of oil, and this led to a jump in expected inflation.
By contrast, more recently, the Fed is expected to act
to
counter the effect of higher oil prices and expected
inflation does not react very much. Because of the smaller
response
of expected inflation, the Fed need not respond as vigorously
to an oil shock as it did in the 1970s. What happened in
the 1970s?
Changing inflation expectations
do not appear to be the entire story, though, as the
estimated effect of an increase
in the price of oil on inflation during the 1970s still
appears implausibly large. Hooker, for instance, finds
that a 1% increase in the relative price of oil caused
an increase of nearly 3% in the core PCEPI over two years
(during the 1962-1980 period). These results are hard
to explain, given the relative size of the energy sector.
For instance, consumer expenditures on energy have never
amounted to 10% of total consumption expenditures over
our sample. Using a formal model, Guerrieri (2005) obtains
results that are consistent with this intuition; in a
situation
where the monetary authority cares about both output
and inflation, a 50% increase in the price of oil lowers
the
level of output by 0.4% after two years and raises the
core PCEPI by 0.2 percentage point. These estimates suggest
that the inflationary impulse from the oil shocks was
not that large. The puzzle then is why economic agents
would
expect a disproportionate increase in inflation--even
if they believed that the Fed would not act to offset this
inflationary impulse.
A comparison of the changes in the
relationship between oil prices and inflation to changes
in the relationship
between commodity prices and inflation suggests one possible
explanation. Hooker's results for oil prices can be replicated
in a small vector autoregression that contains measures
of core inflation, unemployment, and oil prices. The
results are the same if we substitute commodity prices
(excluding
oil) for oil prices. Specifically, commodity prices predict
core PCEPI before 1981, but not after. Others, such as
Furlong and Ingenito (1996), have noted this change in
the predictive power of commodity prices, as well.
It is
well known that commodity prices are sensitive to inflation
expectations. Volatile inflation expectations
may well have dominated the behavior of commodity prices
during the 1970s, which may explain their ability to
predict inflation during that period. The volatile expectations
themselves reflected the conduct of monetary policy.
For
instance, some have suggested policymakers may have believed
they could get permanently higher output in exchange
for higher inflation, so they overstimulated the economy.
As
noted above, policy has become more focused on inflation
since then, and inflation expectations have become better
contained. As a consequence, commodity prices are now
more likely to reflect developments specific to the commodity
sector itself, and these developments may not provide
that
much information about core inflation (or at least no
more than would be suggested by calculations based on a
comparison
of the cost of commodities relative to the price of other
inputs, for instance).
A similar argument may appear harder
to make for oil prices, since their behavior is subject
to the OPEC cartel. However,
one could get the same responses, to the extent that
the cartel or other actors in the market are sensitive
to economic
developments such as changes in the value of the dollar,
and the dollar itself reacts to U.S. monetary policy
and expected inflation. What the markets think
This Letter has argued that oil shocks
are sometimes assigned too large a role in the run-up
in inflation during the
1970s because analysts tend to ignore the part played
by inflation expectations and by monetary policy during
this
period. The implication is that the recent oil shock
should not lead to as much inflation as the 1970s would
suggest.
Financial markets provide confirming evidence.
For instance,
the price of West Texas Intermediate crude oil has risen
by nearly 50% from the beginning of the year
to October 17 (the time of this writing). Over this period,
the yield on 10-year Treasuries has risen by 26 basis
points. The inflation-adjusted rate, as measured by the
rate on
10-year Treasury Inflation Protected Securities has risen
by 26 basis points as well. Thus, the inflation-compensation
component of the yield is unchanged. The 5-year Treasury
yield tells a similar story: the nominal rate has risen
73 basis points over this period, while the real rate
has risen 69 basis points. Thus, the inflation-compensation
component is up slightly. Of course, interest rate movements
over this period reflect the many other developments
that
have also taken place. Even so, it seems safe to say
that there is little evidence to suggest that markets are
expecting
substantially higher inflation as a result of the run-up
in oil prices since the beginning of the year.
As discussed
earlier, this could be because the markets are expecting
the Fed to respond vigorously to the run-up
in oil prices. But a look at the fed funds futures markets
reveals that markets are not expecting very large policy
moves. At the time of this writing, when the fed funds
rate is at 3.75%, futures for December are trading at
4.13% while those for March are trading at 4.41%.
Thus, financial
market expectations do not appear to be out of line with
the statistical analysis. Markets do not
expect the recent substantial rise in oil prices to lead
to a substantial increase in inflation, and they expect
this result to occur without the kind of funds rate increases
one saw in the 1970s. Of course, market forecasts could
be wrong. Bharat Trehan
Research Advisor
References
Bernanke, Ben, Mark Gertler, and Mark Watson. 1997. "Systematic
Monetary Policy and the Effects of Oil Price Shocks." Brookings
Papers on Economic Activity, pp. 91-116.
Clarida, Richard,
Jordi Gali, and Mark Gertler. 2000. "Monetary
Policy Rules and Macroeconomic Stability: Evidence and
Some Theory." Quarterly Journal of Economics,
pp. 147-180.
Furlong, Frederick, and Robert Ingenito. 1996. "Commodity
Prices and Inflation." FRBSF Economic Review 96-2,
pp. 27-47.
http://www.frbsf.org/econrsrch/econrev/96-2/furlong.pdf
Guerrieri,
Luca. 2005. "The Effects of Oil Shocks
on the Global Economy." Mimeo. Board of Governors
of the Federal Reserve System.
Hooker, Mark. 2002. "Are
Oil Shocks Inflationary? Asymmetric and Nonlinear Specifications
versus Changes
in Regime." Journal of Money, Credit, and
Banking,
pp. 540-561.
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