Oil Shocks and Inflation

Mark Thoma channels Bharat Trehan:

Economist's View: Oil Price Shocks and Inflation: This FRBSF Economic Letter looks at oil prices and inflation and finds that oil price shocks are often assigned too much responsibility for the high inflation of the 1970s because the effects of faulty monetary policy and drifting inflationary expectations are underestimated....

Oil Price Shocks and Inflation, by Bharat Trehan, Research Adviser, SF Fed: 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 Letter ... argue[s] 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. ... 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 ..., 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. ... 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...

Jim Hamilton is quoted making similar points. Alan Greenspan views the degree of pass through as an area of considerable uncertainty, but if this research holds up, it implies less pass through of oil shocks to core inflation than commonly assumed, and hence less need for tightening of interest rates to prevent an outbreak of inflation.

It is, I think (or so I tell my classes), important to recognize that there are three things going on in the early 1970s:

1. A tripling of oil prices
2. The erosion of the Federal Reserve's credibility as an inflation fighter
3. A large productivity slowdown, as the rate of labor productivity growth in the American economy falls from 2.5% per year to 1.0% per year and stays there until 1995.

The stagflation of the 1970s is often blamed on (1) along. But I think--and have argued--that (2) and (3) are important factors. See http://www.j-bradford-delong.net/pdf_files/Peacetime_Inflation.pdf.

Comments

[anne]

Also, there was far less international competition in the 1970s and price increases were easily passed through to consumers by producers at all levels. Alan Greenspan has often noted how much more flexible the American economy became during the 1980s. I take this to mean price increases in many areas are less prone to stick. Interestingly in 1980 a pronounced change in drug patenting, easing the patent process, insured an area in which there has been insistent inflation since then. But, drug price increases were largely insured structurally.

[liberal]

"...as the rate of labor productivity growth in the American economy falls from 2.5% per year to 1.0% per year and stays there until 1995."

Isn't it possible that one could reply: "At around which time the statistical bureau's computation of inflation changed, making inflation appear lower, hence GDP and productivity higher."

[anne]

Ordinarily I pay little attention to complaints about the way the price inxes are structured, but analysts such as Barry Ritholtz are complaining so much about these structures that I am at least willing to listen.

[P O'Neill]

There is a trick in all this, though. Trehan says:

>>
But a look at the fed funds futures markets reveals that markets are not expecting very large policy moves. ...
>>

So there's no expected inflation because there's no inflation for the markets to have to expect the Fed to respond to by tightening, as opposed to there being "expected" inflation that won't actually happen because the Fed is expected to tighten to head it off. Which begs the question -- if the Fed has credibility, is rising inflation impossible?

[matt]

I wonder if the productivity decreases were an indirect result of the attacks that had been initiated against unionized workers throughout the 70s culminating in the breaking of PATCO in 1981.

It's a sin that the greatest number of unionized workers today are in the public sector where strikes are not permitted and wage increases don't keep up in any way with the cost of living, or with the wage increases of our elected representatives.

[save_the_rustbelt]

All three were important factors, along with the distraction of the war, the distraction of Watergate, Ford's attempt to regain control, the Dems riding rough shod in Congress, etc. It was a giant mess, made worse by Jimmy "malaise" Carter.

All told, not a pretty picture (some of you are too young to remember 12% inflation and a 20% prime rate).

I don't think any attacks against unions had much to do with it, the UAW, Steelworkers, skilled trades etc. were still riding high.

PATCO had very little to do with private sector unions; dumb management, corrupt union officials and globalization had a great deal more to do with declining unions. And the UAW deserves special mention, considering featherbedding and the old trick of sabotaging cars to supposedly punish managmement (eliminating 750,000 UAW jobs in the process).

[Randall]

Having called unions all the names, now show the least evidence for the charges.

[Auros]

I've also heard that the introduction of widely available consumer credit may've contributed to a surge in inflation, as the average consumer suddenly gained access to more liquidity.

[thibaud]

Shouldn't the oil price spikes also be seen as a consequence, not merely a cause, of the inevitable revaluation downward of the _dollar_ due in part to productivity slowdowns and increased government deficits in the wake of Great Society and Vietnam spending?

[4degreesnorth]

I remember reading your paper when it came out and finding it very good. I do object though to including peacetime in the title: how many tons of bombs were poured onto Vietnam, Laos and Cambodia at the time this peaceful inflation ?