-->My Two Cents (Forty Seven Dollars?) On Oil Q: Why have crude oil prices risen so much this year? A: Because the global demand for it has been rising. This year the global economy will grow at its fastest pace since 2000. The second largest economy in the world, the Japanese economy, which had been in the doldrums for years, is now growing in excess of 5%. Developing economies, such as those of China and India, which are relatively inefficient in their use of energy, are growing rapidly. Although the global investment in fiber optics soared in recent years, there has been considerably less investment in energy extraction, in part because of the previously-low price of energy. So the increased global demand for oil, which has elicited increased production of it, has resulted in a decrease in readily-available spare capacity. With the “tightest” crude oil market in years, the precautionary demand for oil inventories probably has risen inasmuch as near-term demand is not expected to diminish but near-term supplies could be limited due to geo-political events. Q: Could the recent rise in oil prices restrict U.S. economic growth? A: Oil is a critical input for the production of goods and services. If oil were in infinite supply, then the U.S. economy could certainly grow faster than it can with the finite supply of oil. So, yes, the excess demand for oil will, all else the same, slow down U.S. real economic growth. Perhaps another way to understand this is to assume that there is some factor input, call it product “indispensable,” without which no good or service can be produced. Further assume that the physical limit of the availability of indispensable has been reached. With no more indispensable forthcoming there can be no more additional production of goods and services. The lack of supply of indispensable imposes a physical constraint on economic growth. Similarly, the diminishing supply of crude oil relative to the demand for it is beginning to physically constrain the growth in the global economy. Q: What is the correct monetary-policy response to the recent rise in the price of crude oil? A: The knee-jerk prescription is for the Fed to halt its interest rate increases, or perhaps even cut interest rates. After all, there is a presumption that if real economic growth is slowing, then monetary policy must be “biting.” In this case of higher oil prices, that presumption is wrong. Monetary policy affects the nominal demand for goods and services in general. The slower economic growth brought about by higher oil prices is the result of a supply constraint. By holding the fed funds rate constant, or even lowering it, would invite households and businesses to increase the quantity demanded of Fed-created credit so that they could attempt to maintain their purchases of non-oil goods and services in the face of higher oil prices. But this would only worsen the trade-off between higher inflation and faster economic growth. In the extreme, as in the mythical case of exhausted
“indispensable” supply, an easier monetary policy would result in only higher inflation with no increase in real economic growth. Again, monetary policy affects demand. If economic growth is being constrained by some supply factor, then increasing demand via an easier monetary policy will lead to stagflation. Although it may seem counterintuitive and goes against the conventional wisdom, as expressed in Jonathon Fuerbringer’s New York Times article of August 15, “Oil Could Clog Growth’s Motor,” (http://www.nytimes.com/2004/08/15/business/yourmoney/15mark.html) if real economic growth is being constrained by an excess demand for crude oil, the proper Fed response would be to raise interest rates in order to prevent higher inflation. If the Fed views the rise in oil prices as does Fuerbringer, then bondholders will suffer capital losses.
Paul L. Kasriel, Director of Economic Research