In the “RFPC” Sweepstakes, The Top Prize Goes to…

James Hamilton, for asserting that:

Low [oil prices] prices are increasing demand and will also dramatically reduce supply.

Someone, please model that!

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“Misdemeanor”

And a serious one when perpetrated by the IMF´s Chief-Economist with colleagues who write: Oil Prices and the Global Economy: It’s Complicated:

Even though oil is a less important production input than it was three decades ago, that reasoning should work in reverse when oil prices fall, leading to lower production costs, more hiring, and reduced inflation. But this channel causes a problem when central banks cannot lower interest rates. Because the policy interest rate cannot fall further, the decline in inflation (actual and expected) owing to lower production costs raises the real rate of interest, compressing demand and very possibly stifling any increase in output and employment. Indeed, those aggregates may both actually fall. Something like this may be going on at the present time in some economies. Chart 3 is suggestive of a depressing effect of low expected oil prices on expected inflation: it shows the strong recent direct relationship between U.S. oil futures prices and a market-based measure of long-term inflation expectations.

Misdeamenor_1

…Our claim is simply that when an oil importer’s macroeconomic conditions warrant a very low central bank interest rate, a fall in oil prices could move the real interest rate in a way that runs counter to the positive income effect.

But the “causation” they allude to, from oil prices to expected inflation is just a figment of their collective imagination!

If they only looked at a longer time period (beginning in 2003 when the inflation expectation became available), they would have difficulty establishing even a simple correlation.

Misdeamenor_2

What you do notice in the chart above is that oil prices and inflation expectations fall in tandem when there is a negative demand shock. That´s very clear in 2008/09. More recently, since mid-2014, there the Fed has also tightened monetary policy – a negative demand shock. The tightening was initially expressed through Fed words and has been reflected in NGDP growth slipping, expected one year ahead FF rate rising, the dollar index rising (dollar appreciation) in addition to the oil price fall, among other indications of monetary policy tightening!

Misdeamenor_3

 

James, the commodities expert

A James Alexander post

The Market Monetarist view on the reasons for the oil price has been discussed by Marcus NunesDemand fell as global growth has slowed, or at least risen a lot less fast than expected. The demand curve shits to the left as in the chart. But there is another element, supply conditions that have worsened the fall.

The oil supply curve is driven by a lot of things, but two of the biggest are simple cost of production and then the politics of production.

Most commodity cost curves show a long flat line where representing all the existing cheap plays, oil is no exception. And then the curve rises more or less quickly as unconventional or just new, unexplored/low invested capital areas are stuck on the curve. Shale oil is a great example, Artic oil another.

The shape of the cost curve tells us that if the market is in equilibrium on a steep part of the cost curve, a small shift in demand can have quite devastating consequences on the price (Phase One, equilibrium 1 to equilibrium 2).

And then when this happens the politics of oil kicks in as sovereign producers (think Saudi Arabia, Russia and Venezuela) cannot accept for all sorts of reasons less production/less revenues and so shift their production strategies and pump more oil at the lower prices. These changed strategies cause the oil supply curve to shift to the right and the oil price spirals lower (Phase Two, equilibrium 2 to equilibrium 3).

JA Oil

Add the Iraqi, Kurdish and Iranian increases in oil connectivity and it just adds fuel to the fire of falling oil prices and rightward shifting supply curves (pardon the pun).

It’s not the complicated to explain post hoc. Predicting beforehand means predicting monetary policy and the course of international relations, and that´s tough.

Much later, the “Great Inflation” was pinned on poor monetary policy. How long will it take to blame monetary policy for the “repressed economy” since 2008?

The conflicting conclusions from these “old” arguments are still present today!

Alan Blinder (2009)

From the end of 2002 to the middle of 2008, the US economy was in the throes of a significant oil price shock. The dollar price of oil rose fivefold, with spot prices briefly hitting $145/barrel. Even adjusting for inflation, the rise in oil prices was stunning. At their peak, real oil prices stood about 50% above their previous record high – reached following the second OPEC oil shock of 1979-80. (After hitting its 2008 peak, the price of oil fell rapidly, tumbling over the past six months into the $30-$50/barrel range.)

Although the recent run-up in oil prices is comparable in magnitude to the first two OPEC shocks, its effects on the economy seem to have been very different. Textbook accounts of the 1970s and early 1980s blame “supply shocks” (which included sharp rises in the price of food as well as oil) for the prolonged periods of both high unemployment and high inflation, or “stagflation,” that followed.

By contrast, the most recent increase in oil prices appeared to have very little effect on the expansion that followed the 2001 recession. (While the US economy did enter a recession at the end of 2007, this was widely attributed to the collapse in consumer and business confidence that attended the subprime crisis and subsequent financial panic.) Similarly, core consumer price inflation – inflation excluding food and energy prices – was relatively stable over this period, which again contrasts sharply with the earlier episodes.

One interpretation of the experience of the past several years is that it vindicates “revisionist” views of the role played by oil shocks (and other supply shocks) in precipitating the stagflation of the 1970s. According to this view – variants of which have been propounded by DeLong (1997), Barsky and Kilian (2002), and Cecchetti et al. (2007) – the root cause of the abysmal macroeconomic performance from 1973 to 1983 was poor monetary policy, not the oil shocks.

Jim Hamilton (2009)

The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don’t fully believe myself. Unquestionably, there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

Let´s consider Jim´s arguments first: There´s no doubt, just imagining a dynamic AS-AD model that a price shock increases inflation and reduces real output, so Jim´s conclusion is not special. 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:

When will MP take blame_1

There´s an interesting experiment to be made. In 2003-2006 the economy was buffeted by an oil price shock that was even stronger (higher percent price increase) than the one that occurred in 2007-08. This is shown in the charts below.

When will MP take blame_2

As the next charts indicate, in the 2003-06 period NGDP growth was kept stable, so that RGDP growth was only little reduced. This was not the case in 2007-08. In the later period, the Fed remained so worried about inflation that it kept contracting NGDP and that´s the reason a “run of the mill recession” became “Great”!

When will MP take blame_3

Going back to Blinder, he´s very off hand about the “Great Recession”. Unlike the 1970s, he thinks it had nothing to do with monetary policy. Maybe that reflects his concentration on the inflation side of the ledger!

I wonder if it will take another 25 or thirty years for someone to say “the root cause of the abysmal macroeconomic performance from 2008 onwards was extremely poor monetary policy, (not the oil shocks, subprime crisis and ensuing financial panic)

Even The Economist falls into the RFPC trap!

And obviously, whenever you “reason from a price change”,gets nowhere:

IN 2014 oil prices crashed. Americans jumped for joy. Small wonder: each year the average American consumes more energy than a Briton and a Japanese person put together. The oil-price drop pleased economists, too. Many were sure that it would give the economy a nice boost. However, the oil bust was followed not by a boom but a slowdown (see chart). Figures released on April 29th showed that growth in the first quarter of this year was just 0.2%. All this leads wonks to wonder: are lower oil prices such a good thing?

RFPC

………………………………………………………….

In the past few weeks, however, the oil price has stopped falling, so this deflationary effect is wearing off. Economists are left wondering how what seemed like such a big bonus for the American economy could have had so little effect.

Simple answer: It was no bonus! The drop in prices was to a significant extent the result of weak demand, with an also significant effect from an increase in oil supply.