FRBSF Economic Letter
2006-24; September 22, 2006
Oil Prices and the U.S. Trade Deficit
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With the price of oil
in world energy markets having nearly quadrupled over the last
four years, it is little surprise that U.S. import prices have
soared. One concern about these higher import prices relates
to their implications for the U.S. trade balance, which turned
to a deficit in 1992 and has been deteriorating ever since.
This Economic Letter explores
the relation between the surge in oil prices and the trade
deficit by first reviewing data on U.S. international trade
in goods and services. It then discusses a recent study that
examines how the U.S. trade deficit might evolve in response
to higher oil prices. Finally, it considers a model that can
help explain why, surprisingly, the volume of U.S. petroleum
imports has remained essentially constant, despite the remarkable
increase in their cost and what that implies for the trade
deficit.
Has the increase in oil prices affected the U.S.
trade deficit?
 Figure 1 plots monthly
data from January 2002 to July 2006 for both the overall trade
balance and the petroleum-related trade balance; the latter
includes imports and exports of crude oil, fuel oil, liquefied
petroleum gases, and other petroleum products. It shows that
the overall monthly trade deficit went from $30 billion to
$68 billion, and the petroleum-related trade deficit went from
$6 billion to $26 billion. These numbers imply that higher
oil prices and the resulting higher cost of petroleum imports
have accounted for over 50% of the deterioration in the overall
U.S. trade deficit during this period. Indeed, looking at only
the last two years, from August 2004 to July 2006, the data
are more striking. The overall trade deficit grew from $54
billion to $68 billion and the petroleum-related trade deficit
rose from $14 billion to $26 billion, indicating that the deterioration
in the petroleum-related trade deficit accounts for 80% of
the worsening in the overall trade deficit.
How will higher oil prices affect the U.S. trade
deficit?
If oil prices persist
at higher levels, what will happen to the U.S. trade deficit?
Will it continue to deteriorate, or will it level off over
time, or even revert to a balanced position? These questions
are particularly pertinent because oil futures markets indicate
that oil prices may well remain at their relatively high current
levels for the foreseeable future.
To tackle these questions,
Rebucci and Spatafora (2006) examine how an advanced oil-importing
economy like the U.S. adjusts to a permanent increase in the
price of oil. As one would expect, they find that, as the price
of oil rises, the overall trade deficit increases noticeably
relative to its baseline level. In their analysis, the adjustment
process works through the effects of relative price changes
on the nonpetroleum trade deficit. Specifically, as oil imports
become more expensive, households and businesses have fewer
resources to spend on other goods and services, which leads
to a contraction in domestic nonpetroleum demand for consumption
and investment. This contraction, in turn, leads to a decline
in the terms-of-trade, which is the relative price of domestic
tradables in terms of foreign tradables. In particular, lower
domestic demand for nonpetroleum products leads to lower domestic
demand for domestic tradables, which is compensated only in
part by higher foreign demand coming from oil-exporting countries,
which is generated by their higher oil revenues. This effect
is related to "home bias," as domestic tradables
normally represent a disproportionately higher share of domestic
demand than they do of foreign demand. As a result, a
contraction in domestic nonpetroleum demand generates a lower
overall demand for domestic tradables and, correspondingly,
an excess of supply of these goods, leading therefore to a
decline in their relative price. As domestic tradables become
more competitive, export sales increase and the nonpetroleum
trade balance improves. In turn, this improvement helps the
overall trade deficit, so that, eventually, it returns to its
baseline level.
How has this adjustment
process played out in the U.S. so far? During the last two
years, the nonpetroleum trade deficit has not improved but
has actually remained constant, at $44 billion. This suggests
that the adjustment process in the U.S. overall trade deficit
is occurring quite slowly. How long, then, can the adjustment
process take? The answer depends, in part, on the persistence
of the oil price increase: The longer oil prices stay at high
levels, the longer it will take for the trade deficit to adjust.
As Rebucci and Spatafora
point out, the answer also depends on other factors, two of
which I will highlight here. The first factor is the monetary
policy responses of oil-importing countries. Monetary policy,
of course, affects interest rates, which, in turn, affect domestic
aggregate demand and economic growth in oil-importing countries,
ultimately influencing their demand for imports and, therefore,
the evolution of their overall trade deficit. When higher oil
prices start to raise not only headline inflation but also
core inflation—that is, the price measure that excludes food
and energy—the central bank usually tightens monetary policy
to offset the inflationary pressure. The resulting increase
in interest rates dampens domestic aggregate demand even further,
leading to slower economic growth, a decline in the demand
for imports, and a faster improvement in the overall trade
deficit.
In theory, the increase
in interest rates can also induce an offsetting effect on the
trade deficit by appreciating the domestic currency. The currency
appreciation, by making domestic goods relatively more expensive
than imported goods, can lead to a decline in exports, an increase
in imports, and a deterioration in the overall trade deficit.
In reality, however, this effect is likely to be smaller than
the one that works through the reduction in the demand for
imports. In fact, empirical evidence shows that the degree
of pass-through of exchange rate movements to domestic import
prices is quite limited, and that the demand for imports and
exports tends to be rather unresponsive to relative price changes.
As a result, the effect that works through the demand for imports
is likely to dominate, so that an increase in the domestic
interest rate leads to a faster improvement in the overall
trade balance.
How much tightening
the central bank does may depend on how well-anchored the public's
inflation expectations are—in other words, on how firmly the
public expects inflation to stay in the vicinity of price stability
in the future. For example, in the U.S., inflation expectations
appear to be pretty well-anchored, and, as a result, higher
oil prices have had only a limited impact on core inflation;
therefore, with well-anchored expectations, the Fed has not
had to raise interest rates aggressively. Rebucci and Spatafora
conclude that this factor might have helped delay the adjustment
of trade deficits in the U.S. The speed of the adjustment can
also be affected by how strongly the central bank responds
to any increase in inflation expectations and core inflation.
The second factor is
the extent to which oil-exporting countries spend or save their
additional revenues from higher oil prices. In fact, oil-exporting
countries have been quite cautious about increasing their spending
in response to the windfall generated by larger oil revenues.
One consequence of the resulting increase in saving by these
economies has been a larger global supply of funds, helping
to keep global interest rates at lower levels. Rebucci and
Spatafora suggest that unusually low global interest rates
might have limited the contraction in demand, thereby facilitating
the persistence of trade deficits. Obstfeld and Rogoff (1995)
argue that this factor was also at work after the oil-price
increase of the early 1970s; at that time, oil-exporting countries
were unable to raise their spending in line with the increase
in oil revenues. As spending in oil-exporting countries rose
by less than it fell in oil-importing countries, the amount
of global saving increased and helped push global interest
rates down.
Why have U.S. oil imports not declined as oil
prices have increased?
 In the U.S., one additional
factor that has hindered the adjustment of the trade deficit
is that the volume of oil imports has remained essentially
constant. As shown in Figure 2, two measures of oil imports—the
quantity of crude oil imports and the amount of real petroleum-related
imports—have not declined in response to the oil price increases
that began in 2002. As a result, increases in both nominal
expenditures for petroleum imports and the petroleum-related
trade deficit have tracked increases in petroleum import prices
quite closely. Though this finding may seem surprising, Atkeson
and Kehoe (1999) note that this pattern is fairly well known
among energy economists, who have observed that, in the short
run, the use of energy resources, such as oil, is fairly unresponsive
to price movements.
Atkeson and Kehoe construct
a model that captures this feature of the data. The mechanism
underlying their model helps explain why oil imports have not
declined and why the U.S. trade deficit has not adjusted as
oil prices have soared.
In their model oil
enters as an energy input, which is combined with the stock
of existing capital goods to produce consumption goods. These
capital goods are designed to use energy in fixed proportions;
in other words, they require a fixed complement of energy to
operate. Therefore, firms cannot adjust their energy consumption
in response to higher energy prices in the short run.
In the long run, however,
matters are quite different. With persistently higher energy
prices, businesses tend to invest in new types of capital goods
that use lower proportions of energy. As a result, energy use
ultimately is quite responsive to higher energy prices, as
more energy-efficient capital goods replace less energy-efficient
ones over time.
Conclusions
Oil prices have almost
quadrupled since the beginning of 2002. For an oil-importing
country like the U.S., this has substantially increased the
cost of petroleum imports. International trade data suggest
that this increase has exacerbated the deterioration of the
U.S. trade deficit, especially since the second half of 2004.
One factor can explain this evolution: The real volume of U.S.
petroleum imports has remained essentially constant. One explanation
for why the demand for petroleum imports has not declined in
response to higher prices comes from a model in which firms
are fairly limited in their ability to adjust their use of
energy sources, such as oil, in the short term.
Of course, the mechanism
underlying this model may imply that it could take a while
for the U.S. trade deficit to adjust in response to persistently
higher oil prices, as businesses need time to install new,
less energy-intensive equipment. However, one positive and
important implication is that eventually the U.S. economy will
become more energy-efficient, which, in turn, would help contain
the cost of oil imports and increase the economy's flexibility
in absorbing future oil price increases.
Michele Cavallo
Economist
References
[URL accessed September 2006.]
Atkeson, Andrew, and Patrick J. Kehoe. 1999. "Models
of Energy Use: Putty-Putty versus Putty-Clay." American
Economic Review 89(4) (September), pp. 1028-1043.
Obstfeld, Maurice, and Kenneth S. Rogoff. 1995. Foundations
of International Macroeconomics. Cambridge, MA: MIT Press.
Rebucci, Alessandro, and Nikola
Spatafora. 2006. "Oil Prices and Global Imbalances." In IMF
World Economic Outlook (April 2006), pp. 71-96. Washington,
DC: International Monetary Fund.
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
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