Oil and money don’t mix

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.



27 Responses to “Oil and money don’t mix”

  1. Gravatar of Hyena Hyena
    22. September 2011 at 06:29

    Weird. I kept saying this in 2008 and no one would listen, even when I pointed out that subsidy regimes in India and China weakened the impact price increases on the demand of 2.3 billion people (okay, the car-owning fraction, but still). People kept insisting that it was “printing money” (sometimes, SUVs) which caused the increase.

    We do pretend like China, et al don’t exist: we pretend like the only thing which has ever mattered is American policy.

  2. Gravatar of Steve Steve
    22. September 2011 at 06:32

    I’ve been pounding the table about this since 2008 as well, including a few posts on this blog.

    The Fed is inducing tremendous macro volatility by targeting rear-view mirror oil prices.

  3. Gravatar of Scott Sumner Scott Sumner
    22. September 2011 at 06:51

    Hyena and Steve, Yes, I’ve been making the same arguments, but no one is listening.

  4. Gravatar of MikeDC MikeDC
    22. September 2011 at 07:00

    Even with spikes in oil prices, though, overall inflation is well below target using most any sort scheme they could come up with. Pure inflation targeting, Taylor rule, whatever.

    I just can’t seem to wrap my mind around the idea that the Fed (and ECB) as well don’t seem to understand this.

    Why not just say “Look at the CPI! There is no inflation!”

    Oil doubled in real value, didn’t it, under the last few year’s of Greenspan’s tenure, and he managed still managed to hit reasonable inflation targets. I’ve been looking at monthly CPI numbers for the past 50 years or so and trying to make sense of them, and one pattern I see is that under Bernanke there seems to be a lot more variability in month to month inflation.

    I don’t know enough to understand if this means anything, but could it be due to the Fed having less control or talent under Bernanke than under Greenspan?

    If my numbers are right:
    The Greenspan led Fed had delivered mean monthly inflation of .25%, but the standard deviation was .26%.

    The Bernanke led Fed has delivered .2% monthly inflation on average, but the standard deviation is .48%.

    Even if you want to attribute much of that variability to exogenous surprises, the “pre-crises” Bernanke Fed of Feb 06 to Dec 07 had .3% average inflation with a .37% stdev. The initial Greenspan period I calculated (Sep 87 to Feb 90) had a .4% average and .22% stdev. And recall there was the stock market crash two months into his term.

    Look, I’m just an idiot with a spreadsheet and too much free time on my hands, but I’m curious as to why the Fed, as an institution, seemed much more precise under Greenspan than under Bernanke.

  5. Gravatar of Morgan Warstler Morgan Warstler
    22. September 2011 at 07:04

    This post explains WHY the Fed should scream “Drill, Baby, Drill!”

    The Fed should SAY OUT LOUD, if domestic energy production was ramped up, it would stay the effects of headline inflation, and we could be more aggressive.

    Of course the Fed THINKS this.

    They also think we need less regulation and a flatter tax code.

    Because of course, the Fed is an institution that favors private markets by its nature.

    Why do we demand they hide their assumptions?

  6. Gravatar of marcus nunes marcus nunes
    22. September 2011 at 07:09

    Scott. I´ve given you this before, but it´s become pertinent again! From Bernanke Gertler & Watson (97):
    “Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se”.
    So, deep down, he knows that targeting NGDP is a much “safer” proposition!

  7. Gravatar of Steve Steve
    22. September 2011 at 07:11

    Morgan, the Fed is doing the opposite of what you say. It is forcing companies to drill less due to macro instability, and it is allowing the Asians to be white knights buying up unfundable domestic energy assets.

  8. Gravatar of Morgan Warstler Morgan Warstler
    22. September 2011 at 07:34


    tell you what, we can split the difference.

    FIRST, the Fed will come out boldly for ramped up production, saying OUT LOUD, they could be more aggressive with reducing unemployment IF the government got serious about Drill, Baby, Drill.

    SECOND, they can provide macro-stability (Scott style), but we’ll need less printing / devaluing.


  9. Gravatar of Benjamin Cole Benjamin Cole
    22. September 2011 at 08:16

    Superb post,

    I have long thought that oversensitivity to oil prices is a major flaw in US policymaking.

    OPEC and unreliable corrupt backward thug nations control the supply of oil, while prices are set by global demand and NYMEX speculators.

    Cranking up or down the US economy on the basis of wild signals from a jiggered, oligopolized oil price makes very little sense.

    Gold is even a worse clue. Prices are set now in China and India, where 3 billion people are entering the middle-class and buying gold for Auntie and where they are pumping up their money supplies.

  10. Gravatar of TV TV
    22. September 2011 at 08:43

    Excellent post.

    Scott — can you do a post envisioning how the next 10 years play out? It seems like the developing world — not liquidity trapped, will grow and develop. Actually, countries with good monetary policy will grow and develop. Continued rise of China/India seems like it could well put all kinds of upward pressure on the prices of oil/random commodities, right?

    Hence, doesn’t it seem incredibly likely that the scenario you’ve laid out will just happen repeatedly over the next decade or so?

  11. Gravatar of Morgan Warstler Morgan Warstler
    22. September 2011 at 09:55

    Great idea TV, I’d love to see Scott say who he thinks wins Nov 2012.

  12. Gravatar of johnleemk johnleemk
    22. September 2011 at 12:14


    On that note, Huntsman may not be the terrible bet I once thought he was. He’s definitely a sounder bet than Johnson. He’s polling at 10% in NH, ahead of Rick Perry, which I think is arguably more important than national polling. Four years ago Giuliani was polling well nationally but terribly in NH, and he tanked thoroughly.

    I saw Obama speak in NH four years ago and could have shook his hand if I wanted to (I decided not to waste my effort and battle the crowd to shake his hand)…had I known then what I know now, I would have yelled “Target NGDP!” at him until his handlers dragged me away kicking and screaming.

  13. Gravatar of Scott Sumner Scott Sumner
    22. September 2011 at 16:08

    MikeDC, If you use headline inflation, and rates of growth, not level targeting, we are above 2%.

    Morgan, I agree, but the big discoveries will be in other countries (Brazil, Iraq, Russia, etc.)

    Marcus, Thanks for sending me that again. It’s helpful because I do so much I tend to forget things. I agree, but I suppose Bernanke’s out would be that he looks at core inflation. in fact, even core inflation is somewhat affected (indirectly) by oil.

    Thanks Ben,

    TV, I’m also worried that it will re-occur, any time we begin to recover.

    Johnleemk, He seems like a good guy.

  14. Gravatar of Morgan Warstler Morgan Warstler
    22. September 2011 at 17:06

    Scott, shale, oil sands, and nukes.

  15. Gravatar of Morgan Warstler Morgan Warstler
    22. September 2011 at 17:07

    Natural gas.

  16. Gravatar of o. nate o. nate
    22. September 2011 at 19:04

    What was NGDP growth like in the ’70s? In other words, how far off was Fed policy from what it should have been under an NGDP-targeting regime?

  17. Gravatar of o. nate o. nate
    22. September 2011 at 19:11

    I’ll answer my own question: it looks like NGDP growth averaged about 10% (annualized) in the ’70s:


  18. Gravatar of Noah Yetter Noah Yetter
    22. September 2011 at 19:19

    The fundamental error, from which the economics profession has never recovered, was redefining “inflation” to mean “an increase in the price level”. Had we kept its original definition, “an increase in the money supply,” we could have avoided nearly a century of misguided theorizing and poor policy construction.

  19. Gravatar of marcus nunes marcus nunes
    22. September 2011 at 19:42

    @ o. nate
    Look at the pictures and make up your story!

  20. Gravatar of cato cato
    23. September 2011 at 02:48

    its not just oil, its any good… the fed should abandon bothering trying to measure “inflation”. we know real growth is about 3% long term so nominal growth can just be 3 + x where x > 0, say 2 like you recommend.

    why bother trying to work out whether a price is a real rise or inflation, also why distort the market clearing mechanism (ie price) by fucking around with monetary policy based on some good, any good.

    we will look back on this time as the dark ages where practising macroeconomists (ie the fed, rba) resorted to voodoo of interest rates and inflation rather than just doing their job of supplying the right amount of money, that is enough to cover real GDP with nominal GDP.

    the cart is before the horse, but probably later we’ll have the sumnerian century…

  21. Gravatar of flow5 flow5
    23. September 2011 at 03:42

    “Yes, the Fed didn’t know we were in recession, because of data lags”

    That’s not what the data says. If your data lags, your using the wrong data. That’s why the taylor rule is junk.

  22. Gravatar of StatsGuy StatsGuy
    23. September 2011 at 04:15

    Scott, thanks for posting on this topic – I’ve been at a conference (in Europe) since last Saturday and very busy, didn’t even see this. And yes, the sentiment there is about as bad we all would expect, and no one likes Greece.

    I would add only this: The Fed (and ECB) are doing tremendous STRUCTURAL damage by over-targeting (rear-looking) headline inflation. That doesn’t mean I don’t think headline inflation is important (it’s quite real, particularly if you’re in the lower income strata), but it’s counterproductive.

    Why? Essentially, we’re knee-capping the economy to drop AD to bring down the price of oil (in dollars), which in a sense is SUSTAINING THE OIL INTENSITY OF THE ECONOMY to a great degree than is optimal. What do I mean by that? Simply this: if the price of oil went up (relative to labor and debt), then economic actors would accelerate substitution away from oil – that is, they would substitute more people and more technology for expensive oil. INSTEAD, we’re dropping oil use not by encouraging substitution to alternatives (including increasing labor intensity, which would help with unemployment) but by preserving the current oil intensity and reducing overall consumption (including reduction of consumption of non-oil-intense products, like digital “goods”). It’s dumb.

    In a sense, that Fed policy is also encouraging developing economies to move toward a more oil-intense infrastucture than would otherwise exist if oil were priced higher. It is encouraging LESS drilling, LESS technological innovation in the drilling sector, LESS demand for fuel efficient vehicles, LESS investment in alternative transportation, and WORSE city planning.

    And this does not even take into account the cost of the effective subsidies for drilling, the largest of which was the 4 Trillion that has been and will be spent on Iraq, Afghanistan, and living with the long term costs of those wars.

    Anyway, compare and contrast Fed action vs. the long term price of Brent Crude Oil (NOT west texas, which is less relevant internationally).


    Look a the five year chart – look at where the Fed permitted tightening, and where it finally responded to intervention. If we believe that chart, the Fed’s effective target for Brent is going to be well under $100, which probably means a much stronger dollar, and we’re not there yet. The Fed is forcing a dollar short squeeze again (effectively targeting assets like the Euro, the Swiss Franc, oil, gold, commodities) until it gets headline inflation down. It’s not satisfied. It needs to drop the price of Brent to the point where it can offer an intervention that has enough room to run without bringing Brent back over $100 too quickly. I’m guessing that will be slightly above where it was in 2010 (the Fed is letting oil rise, just more slowly than it should), so probably in the $80 to $85 range before we see any real Fed move.

    From now on, Scott, I’m going to macro time the market when making investments (which I haven’t been to date). I’ll let you know how it goes.

  23. Gravatar of AirmanSpryShark AirmanSpryShark
    23. September 2011 at 08:34

    You mention that NGDP per capita falling below wage growth leads to unemployment; why not advocate targeting the growth of NGDP per capita, rather than NGDP itself?

    I realize that the targeting would then be done against a combination of two noisy data streams rather than one, but it would (at least slightly) future-proof the policy (e.g., if immigration policy were substantially liberalized, NGDP/cap could fall due to acceleration in the population growth rate even if NGDP growth was perfectly on target).

  24. Gravatar of Scott Sumner Scott Sumner
    26. September 2011 at 06:28

    Noah, So inflation causes inflation? If not, what causes inflation?

    Cato, I hope so.

    Flow5, That’s right we needs NGDP futures contracts–no lags there.

    Statsguy, Great comment.

    Airman, I actually do prefer the per capita version. But since US population growth is usually stable, I tend to gloss over that for simplicity.

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