Matt Yglesias is on the right track

Matt asks: Do High Oil Prices Doom The US Economy?

And tentatively gives an answer:

But it looks to me as if a demand-side oil issue is really just the same old issue of the trade deficit and the international balance of payments and not the second coming of a 1970s-style oil price shock. Perhaps it’s a monetary policy issue. We send dollars abroad in exchange for oil, but then the dollars get sent back in exchange for bonds. That ought to lower interest rates and induce investment in the United States, but nominal interest rates are already at zero so the loop is cut. Even so, higher gas prices should push the price level up which pushes real interest rates down which induces investment in the United States. The chain will only be broken here if the Fed decides to ignore its own self-guidance and target headline inflation instead of core inflation. If you do what the ECB does and react to an increase in the price of oil imports with tighter money, then clearly higher oil prices slow growth. But that’s the ECB blundering (a specialty in Frankfurt) not oil prices strangling growth per se.

Matt, you are on the right track. This is the conclusion of a paper by Bernanke and Gertler (Systematic Monetary Policy and Oil Price Shocks) written in 1997:

Substantively, our results suggest that an important part of the effect of the oil price shocks on the economy results NOT from the change in oil prices per se, but from the resulting tightening of monetary policy. This finding may help explain the apparently large effects of oil price changes found by Hamilton (1983) and many others.

The paper is obviously technical, so only the cognoscenti will be able to read it through. But no matter, there´s a very simple way to show why the conclusion makes sense, and also why Market Monetarists think it´s preferable to target nominal spending  (NGDP), level target, instead of inflation (BTW, Matt is right in thinking that targeting Headline inflation is worse than targeting Core inflation).

There´s no doubt, just imagining a dynamic AS-AD model that an oil price shock increases inflation and reduces real output, but the strength of the oil price effect on real output is predicated on how the Fed reacts to the shock.

If the Fed reacts to the rise in inflation by contracting nominal spending (NGDP), real output is going to decrease more than if the Fed kept nominal spending “constant”. This is clearly seen in the following graph, representing a dynamic AS-AD model, where point 1 is the initial state and points 2 and 3 represent, respectively, the states following the oil price shock and the oil shock cum contraction in AD:

So it´s  very frustrating, to say the least, to see that in 2008, when the economy was already nominally weakened from the fall in house prices and its effects on the financial sector, that Bernanke should have reacted to Headline inflation, which reflected the rise in oil and commodity prices, giving way to the largest nominal spending contraction since 1938. That´s the proverbial “throwing lots of salt in an open wound”. The pain just “shoots up”!

5 thoughts on “Matt Yglesias is on the right track

  1. If the oil shock is a hard supply shock, then RGDP will contract no matter what. The lowest value added uses of oil will be priced out of the economy, like business conventions in Las Vegas or college student trips to Mykonos and Santorini.

    If the Fed does the right thing, i.e., target NGDP, then higher prices in some parts of the value chain will rapidly reallocate capital toward commodity production and efficiency tech. Demand for drilling rigs and small efficient vehicles/appliances/houses will all go UP!

    If the Fed does the wrong thing, i.e., target prices, then it will destabilize the economy and demand for everything will go down (even solar power companies go bankrupt), and the reallocation of resources will take a longer period of time (that’s the 2008 scenario).

  2. Fighting oil prices with tight money is exactly the wrong way to go. We need an expansionary monetary policy, not a Bank of Japan-style suffocation.

    A peevish fixation on inflation—really an unhealthy obsession—does not make a monetary policy. We have seen what the Theo-Monetarists and Econo-Shamans have done to Japan. In 20 years they have had tight money, and real wages down 15 percent, industrial production down 20 percent, property values down 80 percent and the stock market down 75 percent. You like those apples? Why?

    The yen soared—yippee. They have a “strong yen.” Big whoop. They had mild deflation all the way. The facts are that even mild deflation is a growing cancer on a modern economy–that is the empirical record, not a theory.

    Tight money—tight enough to cause deflation—is an epic failure. It just does not work.

    The Market Monetarists have the right take–you need a monetary policy that supports growth and expansion. Moderate inflation is hardly the end of the world, if you can obtain steady growth. I’ll take the deal any day.

    From 1982 to 2008, USA industrial production doubled, and all the while we had inflation in the 2 percent to 6 percent range. Oh, such misery–I wish for such misery all the time. Our lowest inflation in recent times was from 2008-2011, at less than 1.5 percent on the CPI. Great times, no? Such are the glories of deflation and very low inflation.

    Rather than freakishly obsess on a nominal index, economists should become obsessed with what causes growth. Do not genuflect to gold or worship “sound” currency. Worship growth, robust growth and more growth.

    Add on: The Chicken Inflation Littles rant about inflation—but how does one even measure inflation? Hard-core righties like Don Boudreaux of George Mason have written the CPI and other measures are geared to overstate inflation.

    We live in a world of rapidly evolving goods and services. I have a camera that can take 1000 digitals and then send them to Thailand immediately, for zero marginal cost. A generation ago, that would have cost thousands for developing film, and airfreight. People and business easily outperform the government, and the government’s stodgy measurements of inflation.

    Economists are trapped in a room filled with their own inflation farts. Get out of doors, and see the real world.

    Growth is the goal, not a slavish to devotion to stability of an artificial and inaccurate index of prices.

  3. Marcus, you are wrong.

    US energy policy should be to let me pay no attention to Marcus Nunes and drill for oil in his neighbors back yard, and frack in his neightbors front yard, and when Marcus complains, give him the stone face. To bad, pulling oil out trumps all.

    So, the proper monetary policy is TIGHT ENOUGH NGDP level targeting, that all greenie aspirations are destroyed in the process.

    This is the A+++ answer. Everything else is noise.

    Monetary policy only get to matter when it adopts the interests of MONEY HOLDERS, the very people who want to see fiscal spending cut.

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