Must Rising Oil Prices Compel the Fed to Tighten More?

As crude oil prices recently approached $68 a barrel, a Wall Street Journal writer concluded that “inflation fears got an added jolt this week as oil prices rose to a three‐​year high.”


Two other Wall Street Journal writers added that “If crude continues to move higher, it could begin to stifle economic growth.” They suggest that “higher consumer prices for gasoline and other energy products act like a tax, while pushing inflation higher and increasing pressure on the Federal Reserve to raise interest rates more aggressively.” 


Such anxieties about $70 oil are obviously overwrought. Crude prices were usually above $100 from March 2011 to September 2014, yet nobody was then fretting about inflation fears forcing the Fed to raise the fed funds rate. 


But this does raise two very important issues: First, the importance of soaring oil prices in the recession of 2008–2009. Second, the way the Federal Reserve has overreacted to surging oil prices by pushing up interest rates before and during oil‐​shock recessions and (in 2008) leaning against their fall after the recession was well under way.


In May 2009, economist James Hamilton of U.C. San Diego testified before the Joint Economic Committee. He noted that, “Big increases in the price of oil that were associated with events such as the 1973–74 embargo by the Organization of Arab Petroleum Exporting Countries, the Iranian Revolution in 1978, the Iran‐​Iraq War in 1980, and the First Persian Gulf War in 1990 were each followed by global economic recessions. The price of oil doubled between June 2007 and June 2008, a bigger price increase than in any of those four earlier episodes.” 


Like every postwar recession except 1960, the “Great Recession” of 2008-09 was preceded by a spike in the price of crude oil. West Texas crude soared from $54 at the start of 2007 to $145 by mid‐​July 2018. Yet U.S. reporters and economists still write as though the Great Recession had nothing to do with a global energy shock but was instead a “financial crisis” that began with the collapse of an investment bank (Lehman Brothers) on September 15, 2008. This is a stubborn myth.


In reality, the inability of unemployed homeowners to pay their mortgage bills, and the failure of investments tied to those mortgages, were secondary complications of a global energy shock which cut industrial production in Canada and Europe in 2017 before that happened in the U.S. By the end of 2008, the contraction of real GDP “was twice as deep in Germany and Britain  [as it was in the U.S.] and much worse in Japan and Sweden.”


Because energy is a key part of the cost of doing business, higher energy costs made production and distribution less profitable and thereby shrunk the global economy’s supply. Yet even as late as June 2008, as crude prices soared above $140, The New York Times and Washington Post were hysterical about illusory inflation – not recession. 


Did the Fed also mistake a temporary oil price spike for a sustained rise in the overall trend of inflation? I believe it did that in 2008 and even more obviously in prior incidents of a sudden surge in oil prices.


The big oil price spikes (and recessions) between 1973 and 1980 that Hamilton mentioned were clearly matched by huge spikes in the Fed‐​controlled interest rate on federal funds. Oil prices and the fed funds rate were also rising before the 1991 and 2001 recessions. When crude rose from $34 to $74 from May 2004 to June 2006, the fed funds rate rose from 1 percent to 5.25 percent. Once recessions were well underway the Fed always began to bring interest rates back down, but always (including 2008) too slowly.


On January 2, 2008, The Financial Times published my article, “Why I am Not Using the‐​R‐​Word This Time.” Citing James Hamilton, I wrote that “if the emphasis on oil prices in Prof Hamilton’s 1983 study is correct, the US economy is likely to slip into recession because of higher energy costs alone, regardless of what the Fed does. If Mr. Bernanke’s 1997 study is right, timely reductions in the Fed funds rate should avert such a recession.” Once he became Fed chairman, unfortunately, Bernanke did not aggressively cut the funds rate in a timely manner – but instead tried hard to prop rates up. As Cato’s George Selgin documented, “Between December 2007 and September 2008, the Fed sold over $300 billion in Treasury securities, withdrawing a like amount of reserves from the banking system, or just enough to make up for reserves it created through its emergency lending,” One result was to keep the fed funds rate above 2 percent until September when oil prices finally fell. In October the Fed also began paying interest on bank reserves (above 1 percent until mid‐​December) to discourage bank lending. 


Although an oil price of around $70 is only half as high as the peak in 2008, and lower than it was just a few years ago, we do have a lot of experience with sudden increases in oil prices that always ended in recession. And we have a lot of experience with the Fed acting as though they were not focused on “core” inflation at all (i.e., excluding energy) but were unduly influenced by the misleading and ephemeral impact of oil price gyrations on headline inflation numbers. 


So, the Wall Street Journal’s recent warning that “If crude continues to move higher, it could begin to stifle economic growth” would be likely only if crude moved a lot higher. And the warning that a higher oil price must put “pressure on the Federal Reserve to raise interest rates more aggressively” would be likely only if the Fed has still not learned anything from one of its biggest and most frequently repeated mistakes.