1. Oil Price Shocks and the Economy Mine K. Yücel Federal Reserve Bank of Dallas Forum on U.S. Energy Security Traditional and Emerging Challenges January 28, 2002 Resources for the Future, Washington DC

2. Oil Price Shocks and the Economy Do oil price shocks affect economic activity? Do increases and decreases in oil prices affect the economy symmetrically? Is the effect real, or is it the Fed?

3. Oil price spikes tend to be followed by U.S. recessions

4. Do oil price shocks affect economic activity? Eight out of ten post WW2 recessions followed by oil price shocks Statistical evidence links oil prices to inflation, higher interest rates and higher unemployment rates Consensus: An inverse statistical relationship between oil price changes and economic activity

5. How does an oil price change affect the economy? Supply-side economic impacts Reductions in U.S. purchasing power Interaction with monetary policy

6. An unfavorable supply-side shock from higher oil prices Input Scarcity (Higher Oil Prices) GDP Growth Slows & Productivity Growth Slows Wage Growth Slows Unemployment Rate Rises Price Level Rises Interest Rate Rises

7. Purchasing power effects Oil price increase shifts purchasing power from oil-importing nations to oil-exporting nations On net, demand for oil importers goods reduced Lower consumption, lower GDP growth, higher saving and lower interest rates

8. How sensitive is GDP to oil price shocks? Empirical studies: The economys sensitivity to oil price shocks has declined in past decade Monetary policy can shape how oil price shock is experienced: slower growth versus higher inflation

9. Oil price shocks can magnify errors in monetary policy Oil price shock => lower GDP growth, higher inflation Counter-inflationary policy can aggravate GDP losses Expansionary policy can aggravate inflationary pressures

10. Is monetary policy the culprit? Early statistical evidence: no relationship between industry activity and energy intensity--tight monetary policy was the culprit Later evidence: oil price shocks have significant effects on economic activity apart from monetary shocks

11. Is the oil price - economy relationship symmetric? Rising oil prices seem to retard economic activity more than falling oil prices stimulate it. Possible explanation: more economic adjustment costs and coordination problems with rising oil prices

12. Adjustment costs The economy experiences some costly adjustment to both rising and falling oil prices –When oil prices rise, slowing economic activity is further retarded by adjustment costs –When oil prices fall, stimulated economic activity is somewhat offset by adjustment costs We then have asymmetry: rising oil prices retard economic activity by more than falling prices stimulate it

13. The oil price - economy relationship has grown weaker in the past decade Less impact on the underlying (core) inflation rate Less negative effect on unemployment; employment one-half as sensitive to oil price shocks than in the 70s

14. Policy Implications Monetary policy: Neutrality-- balance slower growth versus higher inflation Energy Policy: Lowering short-term oil price spikes--role of Strategic Petroleum Reserve?