It occurs to me that oil shocks explain many of our monetary policy failures.
Consider the recent crisis, which began in 2008. Why didn’t the Fed cut interest rates in mid-September, 2008, the first meeting after Lehman failed? Perhaps one reason was that they were actually considering raising rates in the previous meeting, and the ECB did raise rates at about the same time. But why would they have considered higher rates, NGDP growth was quite slow in early 2008. The economy had already been in recession for 6 month. Yes, the Fed didn’t know we were in recession, because of data lags, but they surely knew growth was slow, and they knew the financial system was under great stress.
The most likely explanation is headline inflation, which had been pushed sharply higher by surging oil prices during mid-2008. By not cutting rates when the Wicksellian equilibrium rate was falling fast, they effectively tightened monetary policy, and the rest is history.
Now let’s look at late 2010. Rumors of QE2 caused all the responses the Fed was looking for. Inflation expectations rose (recall core inflation had fallen to 0.6%) The dollar weakened. Stocks soared. Unemployment fell. What’s not to like? Apparently oil prices, which rose quite sharply.
Let’s put aside the debate over how much of the increase in oil was QE2, how much was rising demand in developing countries combined with peak oil fears, how much was reduced Libyan production, etc. The key point is that if the Fed pays attention to inflation at all, it should be increases in the price of stuff built with American labor. They shouldn’t care about the inflation rate that matches some mythical “cost of living,” as the Fed can’t do anything about adverse supply shocks. They should care about the inflation rate most correlated with macroeconomic stability, which is for stuff built in America. Better yet, target NGDP growth. Don’t let NGDP growth per capita fall sharply below the rate of growth in wages. That means unemployment.
As soon as oil started rising the Fed came under attack, and they folded up like a $3 suit. When the economy clearly was slowing in the spring of 2011, they went ahead with terminating QE2, and didn’t put any more effective program into effect.
Imagine there’s no China. (Or that Mao is still in charge, which is effectively the same assumption.) In that case oil prices fall in the Great Recession, and don’t bounce back up. In that case headline inflation doesn’t average 1% over the past three years; it averages 0% or less. In that case the Fed doves are completely in charge, there is no good argument against stimulus. Now think about how things have been different. Inflation’s been just high enough to give the hawks an argument, weak as it is. China does exist, and this thought experiment shows that China’s demand for oil has effectively sabotaged monetary policy. That’s not China’s fault, we did it to ourselves. We should have operated monetary policy as if China didn’t exist. Instead we let Chinese demand for oil push us into a monetary policy that allowed a bit of inflation, but not nearly enough NGDP growth for full employment.
Ironically, in the 1970s oil caused the opposite problem–excessively expansionary policies. Even before the 1973 oil shock inflation had begun to rise to excessive levels. But after the oil shocks it was clearly way too high. I’m just old enough to remember the constant reassurances from Keynesian economists that it was just a passing problem due to high oil prices. It wasn’t caused by easy money. The monetarists saw the 11% per year growth in M*V during 1972-81, and understood money was the problem. Even without oil we had a major inflation problem, because RGDP only grows about 3%. Eventually the Keynesians learned this lesson from the monetarists, and new Keynesianism was born. Once again we need to teach a new generation of economists to ignore oil and focus on NGDP growth. Let’s hope it doesn’t take a decade, like the last time.
HT: I thank Statsguy for suggesting this post. He probably would have done a better one.