Friday, March 11, 2011

Higher Oil Prices Do Not Equal Higher Trend Inflation

Caroline Baum goes after the confused thinking on oil prices and inflation:
It must be the noxious fumes or the stratospheric prices because crude oil crossing the $100 threshold makes normally thoughtful individuals funny in the head. 

The early symptoms of high oil price syndrome, or HOPS, can easily be masked or confused with a more generalized form of lazy economic thinking. 

For example, those afflicted with HOPS start making assertions that higher oil prices are inflationary, as if relative price changes can morph into an economy-wide rise in prices without help from the central bank. 
One implication of this is that the Fed should not tighten monetary policy since the higher oil prices are just a relative price change.  The Fed should also not loosen monetary policy to ease the pain of such  relative price shocks.  As Baum notes, that is what the Fed did in the 1970s and look what it got us.  The Fed should only respond to aggregate demand shocks.  This piece dovetails nicely with Mark Thoma's  post where he considers whether the Fed should respond to commodity prices in general.  

Update: I should have been more clear: a relative price shock can lead to a higher price level, but not higher trend inflation. There might be a one-time increase in the inflation rate, but not a permanent one from such shocks.  The post title has been adjusted accordingly.


  1. "The Fed should also not loosen monetary policy to ease the pain of such relative price shocks. As Baum notes, that is what the Fed did in the 1970s and look what it got us. "

    On the other hand, the Fed should be loosening monetary policy (regardless of what oil does) because NGDP is still below trend, correct?

    But I doubt Baum would be in favor of such a thing...

  2. Anonymous:

    Absolutely. Stabilize nominal spending and ignore oil shocks.

  3. If there's no inflation and oil prices are higher, then some other stuff must be lower, right? The other stuff isn't other commodities, so what's left? Do higher food and energy prices then drive down housing prices? Given that negative equity in housing is one of the main drivers of banking crisis, won't that impact Fed policy? In a world where the most oversupplied sector-housing- must must supported by the Fed, won't other areas that are not so oversupplied necessarily inflate?

  4. Tinbox:

    For a given income, a relative price change means I spend more on the more expensive good and less on the rest.

    For example, I spend more on fuel, but less on food, clothing, entertainment, etc. Total spending should be the same. The reduction in spending on other goods will be contractionary. So yes, if the Fed tries to counter the relative price shock (instead of keeping nominal spending stable)then that could become inflationary. The hard part is for the Fed to distinguish between relative price changes and aggregate demand shocks.

  5. Not only that but the inelastic demand for oil makes adjusting the price of oil vastly more difficult than adjusting the prices of other goods.

    The only way to adjust oil prices is by adjusting aggregate demand on a truly massive scale - which probably goes against the price stability mandate of every central bank.

    I wrote a post about this:

  6. Yes, at present, it´s all about spending.

  7. while i agree the Fed should stand pat, i'm skeptical that it wont cause inflation & or disruption...

    whether the rise in oil prices will turn out to be a major black swan still remains to be seen, but it's certainly at least another black egret, following on the heels of the weather related food supply disruptions earlier this year...compared to other major oil shocks, the move in oil so far this year is just a wiggle, but even so gasoline alone is already commanding more than 10 cents out of every dollar spent at retail, and that doesnt even count other oil influenced costs, such as heatoil, tires, plastics, and asphalt...and the rising cost of diesel fuel means everything you buy will cost more to transport, especially bulky items like food...

  8. David, why should a relative price shock lead to a higher price level? There are multiple substitution and income effects going on, with the net effect being, as you state, that total spending should be the same. To the extent that the substitution effects are not reflected in the weights of the goods and services in the CPI, then yes, the price level as imprecisely measured by the CPI would go up. Or perhaps the prices of other items are stickier than gas, so they don't adjust immediately downward, and hence the rise in the price level and a contractionary impact on the economy?

    Things get murkier if the effects on inflationary expectations are taken into account, and in an economy where said expectations are not firmly anchored, the central bank would have to accomodate them through an increase in inflation or else induce a recession like Volcker did.

  9. If the impact of this non-inflationary relative price shock (higher oil prices) is to lower spending on housing, then we all know that the Fed will have no choice but to take action, right? And that action will be to continue to support the pricing of the most over-supplied sector of the economy, no? So what is your alternative scenario where the Fed does not counter this relative price shock with a policy that is inflationary?

  10. Anonymous:

    I said the relative price shock can lead to a higher price level not that it necessarily will. I was trying to make the point that even if the relative price shock does raise the price level it would only be a one-time rise versus a sustained rise in inflation.

    But you are correct, it would require clearing some big hurdles to happen. It would have to be some combination of the following: (1) unusually large shock; (2)item had a sizable weight in the CPI; (3) other prices more sticky on average; and (4) and some unmeasured substitution effects.

  11. If there is a shift in the composition of demand, say people decide to drive gas guzzlers and live in smaller homes, then the shift in relative prices isn't inflationary. Some prices fall and others rise.

    If, on the other hand, there is a reduction in the supply of gasoline, then this raises the price of gas, and by arithmatic, raises the price level. The shift in the price level is a higher inflation rate.

    It is possible to reverse this increase in the price level, (and with trully God-like policy powers to prevent it) by a strongly contractionary monetary policy. The prices of other goods will be forced down (and the price of gas will be lower than it otherwise would without the policy.)

    What happens to spending on gasoline due to the supply shock depends on the elasticity of demand. With unit elasticity, total spending stays the same. The price level is higher, however, by arithmatic, as above. Higher price of gase, (lower output of gas) and the same for everything else.

    If inelastic demand, spending on gase rises, and spending on other stuff falls. If total spending is targeted (which I favor,) then there is a modest contraction in other areas. The price level, however still rises. That is true because less oil is less output and with the same total spending, the price level is higher.

    With elastic demand, spending in the rest of the economy actually expands. less spending on gas, and more spending on other things. The price of gas and other things rise. Output is less (less gas) and the price level is higher.

    With the sort of bad policy regime we have today, where it is about interest rates and expected inflation, the key worry is about how the increase in the inflation rate will impact inflationary expectations. A given interest rate target, and higher inflationary expectations, could be explosive. That is why we need to get rid of this policy regime.