Oil Prices and the Macroeconomy
In this issue, we focus on how the oil price can affect the global economy. Paul Segal gives us insight on the role of the oil price in the macroeconomy. – Francesco Verre, Oleg Zhdaneev, and José Condor-Tarco, Editors, Economist's Corner
Oil prices and economic cycles have been linked in the public imagination since the oil shocks of the 1970s, and the global recessions that followed. But until the credit crunch hit in late 2007, the world had witnessed high and rising oil prices with no observable slowdown in growth. So what role has the oil price played in the world economy?
One of the responses to the shocks of the 1970s was a plethora of econometric studies. The message seemed clear: oil shocks cause recessions. Yet more recent work has found that the relationship did not last. With longer time-series data, it looks like oil prices lost their impact on the macroeconomy only shortly after the global slowdown of the early 1980s. Fig. 1 shows petroleum expenditures as a share of gross domestic product (GDP) for the world’s major economies between 1970 and the present.
Did oil prices really stop having an impact after the early 80s? Not quite, but the relationship has to be disentangled. When oil prices go up, producers of goods that use oil face increased costs. Some of these producers may go out of business, and others will survive and pass on some of their increased costs to consumers. This rise in prices is referred to as the first-round, or direct, effect on inflation.
But this first-round effect will reduce output only to the extent that less oil is actually used. If you do the arithmetic, it turns out that oil shocks can have only a very small impact on output in the first round. Consider the US. The largest decline in oil usage occurred over 1979–80, when consumption dropped by 7.4%. Accounting for the fact that oil expenditures reached a maximum of about 8% of GDP, this can only explain a decline in GDP of 0.6 percentage points. This is not nearly enough to turn a year of normal growth into a recession, and cannot explain the US recession of 1980.
What can explain a recession is a monetary-policy response to inflation. For an oil importer, a rise in the price of oil means that the country is poorer as a whole. No matter what policy action the country takes, its terms of trade have deteriorated. The second-round, or indirect, effects occur when people in the oil-importing economy are unwilling to accept this loss in income—when businesses raise prices to maintain profits, or unions demand wage rises that fully compensate the first-round rise in prices. The bottom line is that someone has to be poorer. So if businesses and workers all refuse to take a cut in income, then the result can be a wage-price spiral.
This is a fair description of much of the 1970s. But in 1979, the US Federal Reserve decided that enough was enough, regarding inflation. Interest rates were allowed to rise throughout 1979 and into 1980, causing a recession that brought inflation back under control. It was this monetary-policy response, not the oil price per se, that caused the recession.
This anecdote is supported by formal econometric evidence, including work by the current Chairman of the US Federal Reserve Board, Ben Bernanke. In an important econometric study he showed that when monetary policy is fully accounted for, the oil price has never had a substantial, independent impact on output. Other studies have supported this finding.
This explanation also is supported by the experience of the last 5 years. Why? Because the big difference between the oil price rise up to mid-2008 and the shocks of the 1970s is that the second-round effects were absent in the more recent instance. Wages did not rise in response to a higher cost of living, and businesses passed on less of their cost increases into prices. Oil importers seem to have learned to live with the deterioration in the terms of trade.
The explanation for this change is not clear. But it probably involves two factors. First, unions are weaker than in the 1970s. Second, monetary policy is more credible, as market participants know that a wage-price spiral would be crushed by the policy response. The threat of action can be enough. With no second-round effects, inflation remained modest during 2007, and no hike in interest rates was required.
This is not to say that first-round inflation remained trivial. In 2008, inflation rose to worrying levels, causing central banks some concern. It was driven by the rise in international commodity prices, including the oil price. But this means that what looked like inflation was really just a decline in the terms of trade for commodity importers. The only way to bring down overall inflation would have been by causing deflation in other goods. This argued for accommodating the temporary rise in prices, and indeed cutting interest rates to counter the first-round effect on output. The risk in this strategy was the possibility that market participants would not have understood the temporary nature of the price rise, which could have led to a rise in inflationary expectations.
This dilemma disappeared with the end of the era of high commodity prices. Oil prices have collapsed from their high of nearly USD 150 to less than USD 50, and the world is now concerned about deflation and a lack of aggregate demand, rather than inflation. But low oil prices will not contribute to the fear of a decline in the overall price level. On the contrary, low oil prices can help to increase demand for other goods. In an environment of strong aggregate demand and high inflation, a fall in the oil price would have added further inflationary pressures, and central banks may have needed to tighten monetary policy. In the present environment, low oil prices are a complement to the loose monetary policy and fiscal stimulus being implemented by many of the world’s central banks.
Paul Segal is a Research Fellow at the Oxford Institute for Energy Studies and a Junior Research Fellow at New College, Oxford. His research interests include the distribution of income and resource wealth in resource-rich countries and the macroeconomics of oil prices. Segal has been a Research Fellow at Harvard University’s Global Equity Initiative and a Consultant Economist at the United Nations Development Program. He completed his PhD at Nuffield College, Oxford, in 2006.
12 February 2018