FRBSF Economic Letter
2005-31; November 18, 2005
Why Hasn't the Jump in Oil Prices Led to a Recession?
Oil prices have increased substantially over the last
several years. When oil price increases of this magnitude
occurred during the 1970s, they were associated with severe
recessions. Why hasn't that happened this time around?
This Letter explores some answers to that question.
Why should oil affect the
economy?
When the price of oil rises, U.S. households and businesses
who purchase fuel oil, gasoline, and other petroleum-based
products have less disposable income to spend on other
goods and services. However, for domestically produced
oil, oil producers receive the extra income from the products
they sell, so total U.S. income is not directly affected.
Therefore, for domestic oil, a price increase represents
a transfer from one group of U.S. residents (oil users)
to another group of U.S. residents (oil producers).
The story is different for imported oil. An intuitive
way to think about the initial effects of an increase in
the
price of imported oil on the economy is to consider it
as a tax on domestic users. In 2004, the U.S. imported
almost 5 billion barrels of energy-related petroleum
products, amounting to about two-thirds of domestic petroleum
use.
Of these imports, 3.8 billion barrels were crude petroleum,
or an average of 10.4 million barrels per day. For each
$10/barrel increase in oil prices, the United States
pays an effective "tax" of about $50 billion
(5 billion barrels times $10), or 0.4% of GDP.
This is not the same thing as saying that GDP will fall
by 0.4%. For instance, this estimate does not take
into account what the foreign oil producers do with the
additional
income. It is likely that they would use at least part
of this income to purchase goods from other countries.
To the extent that these purchases consist of goods
made in the U.S., they will help support U.S. GDP. Indeed,
it is possible—in theory—to conceive of a situation
where
foreign oil producers purchase enough from the U.S.
that
U.S. GDP does not decline much, even though consumers
are paying a higher price for oil and therefore can
afford fewer goods and services themselves.
How big is the effect in
practice?
 As mentioned earlier, the experience of the 1970s suggests
that oil shocks have a substantial effect on output. Indeed,
Figure 1, which plots the real, inflation-adjusted price
of imported petroleum, shows that high oil prices have
frequently coincided with recessions. In a series of papers,
Hamilton (1983, 1996, 2003) has argued forcefully that
the oil shocks were responsible for these recessions. However,
he argues that not all changes in the price of oil have
the same effect on the economy. For instance, a fall in
oil prices is unlikely to boost the economy in the same
way that an increase can drag it down. In addition, he
argues that oil price increases that simply reverse previous
price decreases are unlikely to have a significant effect.
One approach he recommends to isolate the kinds of price
changes that can affect the economy is to record an oil
shock only if the prevailing price of oil is higher than
it has been over the past three years.
 Figure 2 plots oil price shocks according to this recommendation.
The spikes line up closely with recessions. From the
figure, it is easy to find a clear statistical relationship
between
this oil-shock variable and output. Indeed, the magnitude
of the predicted effect is much larger than the simple
tax analogy suggests. This could reflect some sort of
multiplier, as the loss in income in the first round would
lead to
a reduction in spending, which would imply a further
loss in income, and so on. However, a simple statistical
analysis
does not provide insight into why the magnitude is so
much larger than the direct income loss.
Moreover, the statistical evidence is not necessarily
as strong as Figure 2 might suggest. Because an oil
price shock is recorded if and only if oil reaches a three-year
high, a temporary increase in the price of oil is treated
as having the same impact as a permanent increase.
But
if the spike is temporary, then the effects on income
are
fleeting, and one would expect that many consumers
will reduce their saving in order to avoid a big hit to
consumption.
To see the point, compare the 1990 experience in Figures
1 and 2. Figure 1 shows that the price of oil spiked
only briefly. But in Figure 2, which uses the Hamilton
price-increase
transformation, the 1990 spike was one of the largest.
In Figure 2, this spike is followed by a long series
of zeros. In Figure 1, however, more than 95% of
the oil price
increase is reversed next quarter and oil prices
over the next year or two appear no different from the
period
preceding
the spike. Indeed, more formal statistical analysis
shows that over the post-1982 period the Hamilton
oil shock
variable has a significant negative impact on output
only because
of the spike in 1990. If the 1990 spike is set to
zero, there is no evidence of a statistically important
relationship.
Note also that the timing is suspect in several cases.
The 1973-1975 recession began in November 1973;
but oil prices surged in January 1974. The 1990-1991
recession began in July 1990; but oil prices surged
in August.
Another way to get a sense of how large the effect
of oil shocks may be is to consider the implications
of
more fully
specified models, which incorporate the direct
expenditure effects but then allow for additional,
second round
effects. These tend to suggest that the ultimate
effects are roughly
in line with the direct expenditure shares. In
a recent paper, Guerrieri (2005) finds that a
50% increase
in
the price of oil starting in the first quarter
of 2004 causes
output to fall about 0.4% below what it would
otherwise be in the long run (assuming that the Fed conducts
policy using the well-known Taylor rule). The
effects
are likely
to have been larger in the 1970s, when the economy
was more energy-intensive; however, even if we
assume that
the economy's energy-intensity is unchanged since
the 1970s, the effect is not likely to be huge.
Other explanations for
the 1970s
Considerations like these have led a number of economists
to suggest that the recessions of the 1970s reflected other
kinds of shocks. For instance, Barsky and Killian (2001)
argue that the great stagflation of the 1970s was the result
of monetary policy alternating between periods of stimulation
and restraint and not oil price shocks. Similarly, Burbidge
and Harrison (1984) examine developments in five major
industrial economies including the U.S. and conclude that
even though the oil shocks in the early 1970s did have
a significant effect, recessions were already on the way
even before the jump in oil prices. They also find that
the 1979-1980 oil shocks had a minimal effect on all these
countries except Japan.
Others have argued that the recessions may have been
caused by the Fed's reaction to the oil shocks. Bernanke,
Gertler,
and Watson (1997) show that postwar recessions have been
preceded not only by rising oil prices but also by a
tightening of monetary policy, which makes it difficult
to distinguish
between the effects of the two. According to them, the
confusion between oil shocks and the response of monetary
policy explains why oil shocks appear to have an effect
that far exceeds what is expected based on a comparison
of energy costs to total production costs. Their own
analysis leads them to conclude that oil shocks have not
played
a major role in recessions and that endogenous monetary
policy can account for a major portion (and sometimes
all) of the effects attributed to oil shocks.
Is the current episode
different?
It has also been suggested that the latest jump in oil
prices has not had the usual effect on the economy because
the price of oil has jumped for different reasons. For
example, in the 1970s, the OPEC oil embargo and the fall
of the Shah of Iran led to substantial reductions in the
world supply of oil; similarly, the world supply fell in
1990 after Iraq's invasion of Kuwait. These seem like exogenous
shocks to the world supply.
But much of the run-up in oil prices in the past few
years seems to reflect the endogenous response of prices
to the
strength of global demand. The source of this higher
demand turns out to be important. If the higher prices
were the
result of higher U.S. demand, then there would be little
reason to fear a recession. It is hard to believe that
the "tax" imposed by the oil price increase would
exceed the increase in income that was the cause of the
higher oil demand. But if the increase in demand originates
abroad, things get more complicated. For instance, high
oil prices which reflected rapid growth in China would
have the same direct impact on the U.S. as a price increase
engineered by OPEC, basically because higher oil consumption
in China coupled with a relatively inelastic supply means
that less oil is available to the U.S. There is a potential
offset to this effect, as more rapid growth in China is
likely to be accompanied by higher imports. Thus, countries
that export significant amounts to China relative to their
size will benefit from the rapid Chinese growth. The U.S.
is not one of these countries, however, so that for the
U.S. an increase in the price of oil due to higher demand
from China is probably similar to an increase due to a
reduction in supply.
Conclusion
Our discussion suggests that the answer to the question
posed in the title has two parts. First, looking only
at the correlation between some measure of the price
of oil and output tends to exaggerate the role that
oil price shocks played in the recessions of the 1970s,
at
least partly because one ends up ignoring the other
things that were going on at that time. Second, an increase
in the price of oil that reflects higher demand will
not have the same effect as a decrease in supply. Here,
though, it is useful to keep in mind that price increases
that reflect higher growth in other countries will
have
the same effect on the U.S. as price increases that
reflect a reduction in the worldwide supply of oil—unless
U.S.
exports to these fast growing countries account for
a significant share of U.S. output.
John Fernald
Vice President
Bharat Trehan
Research Advisor
References
Barsky, Robert, and Lutz Killian. 2001. "Do We
Really Know That Oil Caused the Great Stagflation?" NBER
Working Paper 8389.
Bernanke, Benjamin, Mark Gertler, and Mark Watson.
1997. "Systematic
Monetary Policy and the Effects of Oil Price Shocks." Brookings
Papers on Economic Activity, pp. 91-116.
Burbidge, John, and Alan Harrison. 1984. "Testing
for the Effects of Oil-Price Rises Using Vector Autoregressions." International
Economic Review 25(2), pp. 459-484.
Guerrieri, Luca. 2005. "The Effects of Oil Shocks
on the Global Economy." Mimeo.
Hamilton, James. 1983 "Oil and the Macroeconomy
since World War II." Journal of Political
Economy 91(2), pp. 228-248.
Hamilton, James. 1996. "This Is What Happened to
the Oil Price-Macroeconomy Relationship." Journal
of Monetary Economics 38(2), pp. 215-220.
Hamilton, James. 2003. "What Is an Oil Shock?" Journal
of Econometrics 113 (April), pp. 363-398.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
