Oil and the Macroeconomy

Two empirical relationships about the effect of oil prices on the U.S. economy are well accepted. The first is that while oil price increases lowered real GDP growth in the 1970’s, since then changes in oil prices have had no significant effect on U.S. economic activity. Second, while oil price changes continue to change core inflation in the U.S. based only on their expenditure share of price indices, since the 1980’s they have no longer had an additional impact on core inflation. The Fed’s reaction to oil price has also shifted. During the 1970’s, prior to Paul Volcker’s chairmanship, the Fed tightened monetary policy in response to rising oil prices. This policy response can be justified since, as pointed above, oil prices led core inflation during this time period. Of course, history suggests that the Fed’s responsiveness during this period was also insufficiently aggressive to keep inflation from accelerating. While oil prices changes do not seem to have played a direct role in Chairman Volcker’s implementation of monetary policy, during Chairman Greenspan’s tenure the Fed has acted to keep monetary policy looser in response to an oil price rise. Indeed, I calculate that the recent 50 percent rise in oil prices may account for the federal funds rate being 50 to 100 basis points below where it would be otherwise. This is not to say that Greenspan has taken his eye off inflation. He has managed to keep inflation low and he has acted aggressively against increases in inflation expectations. Nevertheless, the wisdom of this new accommodative response to oil price changes is unclear. Oil price spikes (both up and down) are short lived and may not even have a direct effect on U.S. economic activity, as recent evidence seems to indicate. A policy that responds to oil prices may foster a monetary policy environment of “fine tuning”, rather than one based on maintaining low inflation