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Saturday, October 29, 2005

Oil Price Shocks and Inflation

This FRBSF Economic Letter looks at oil prices and inflation and finds that oil price shocks are often assigned too much responsibility for the high inflation of the 1970s because the effects of faulty monetary policy and drifting inflationary expectations are underestimated. Here is a short version of the paper:

Oil Price Shocks and Inflation, by Bharat Trehan, Research Adviser, SF Fed: Oil prices have risen sharply over the last year, leading to concerns that we could see a repeat of the 1970s, when rising oil prices were accompanied by severe recessions and surging inflation. ... This Letter ... argue[s] that oil shocks are sometimes assigned too large a role in the run-up in inflation during the 1970s because analysts tend to ignore the part played by inflation expectations and by monetary policy during this period. The implication is that the recent oil shock should not lead to as much inflation as the 1970s would suggest. Financial markets provide confirming evidence. ... there is little evidence to suggest that markets are expecting substantially higher inflation as a result of the run-up in oil prices since the beginning of the year. As discussed ..., this could be because the markets are expecting the Fed to respond vigorously to the run-up in oil prices. But a look at the fed funds futures markets reveals that markets are not expecting very large policy moves. ... Thus, financial market expectations do not appear to be out of line with the statistical analysis. Markets do not expect the recent substantial rise in oil prices to lead to a substantial increase in inflation, and they expect this result to occur without the kind of funds rate increases one saw in the 1970s...

Jim Hamilton is quoted making similar points. Alan Greenspan views the degree of pass through as an area of considerable uncertainty, but if this research holds up, it implies less pass through of oil shocks to core inflation than commonly assumed, and hence less need for tightening of interest rates to prevent an outbreak of inflation.

[Update: Brad DeLong comments.]

    Posted by on Saturday, October 29, 2005 at 01:52 AM in Economics, Inflation, Monetary Policy, Oil | Permalink  TrackBack (2)  Comments (10)

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    Mark Thoma channels Bharat Trehan: Economist's View: Oil Price Shocks and Inflation: This FRBSF Economic Letter looks at oil prices and inflation and finds that oil price shocks are often assigned too much responsibility for the high inflation of the 1... [Read More]

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    » Oil Shocks and Inflation from Brad DeLong's Website

    Mark Thoma channels Bharat Trehan: Economist's View: Oil Price Shocks and Inflation: This FRBSF Economic Letter looks at oil prices and inflation and finds that oil price shocks are often assigned too much responsibility for the high inflation of the 1... [Read More]

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