Oil price shock ensures recession—empirics prove

An oil price shock is one of several possible disturbances to a country's aggregate price level. Its significance reflects the fact that crude oil is an important energy source for most industrialized countries, who use energy as a direct or indirect input in the production of most goods and services. Because higher oil prices tend to raise the prices of petroleum-based products and alternative sources of energy, such as natural gas, the aggregate price level will rise unless the prices of all other goods and services fall to offset the rise in oil prices. Of course, oil price shocks are not always one-sided. Prices of crude oil can also fall in significant fashion, as they did in 1986 and 1998. On balance, though, the public and policy-makers tend to think of oil price shocks as energy price increases, hence, the adverse connotation.

In the early post-World War II period, the run-up in energy prices prior to economic downturns was comparatively mild. During the four quarters preceding the onset of the 1948-49, 1953-54, 1957-58, 1960-61 and 1969-70 contractions, the relative (real) price of energy increased a little more than 1.5 percent, on average. These increases, however, were tempered by the fact that the relative price of energy actually declined 2.4 percent and 1 percent prior to the 1960-61 and 1969-70 contractions, respectively—though energy prices subsequently rose sharply in the midst of these two recessions.

The below shows that energy price changes have been much more pronounced (relative to output prices) since the early 1970s. The average increase in real energy prices prior to the onset of the four recessions during this period—1973-75, 1980, 1981-82 and 1990-91—was 17.5 percent, much greater than in earlier recessions. Except for the 1990-91 recession, one of the mildest since World War II, the contractions of the 1970s and 1980s were the deepest since the Great Depression. Though U.S. economic growth remained solid through the third quarter of 2000, the 23 percent increase in real oil prices from four quarters earlier is nevertheless large in historical terms.

Rising Oil Prices Have Usually Preceded Most Recessions

As the figure shows, nearly all post-World War II recessions in the United States were preceded by, or accompanied by, a sharp increase in energy prices relative to the aggregate price level. As a result, oil price shocks tend to be viewed with alarm by macroeconomists, markets and public policy-makers. This heightened sense of concern is largely an outcropping of the 1970s and 1980s.

One reason why oil prices have been more volatile since the 1970s has been the advent of the Organization of Petroleum Exporting Countries (OPEC). Economically, OPEC is a cartel—a type of oligopoly that attempts to keep prices above their competitive levels by actively adjusting crude oil supplies. Last year, for example, OPEC oil ministers announced that they intended to alter production to keep the market price of crude oil between $22 and $28 a barrel. OPEC has also tried to manipulate prices for political reasons. The best-known example was the 1973 Arab oil "embargo," which sought to punish the United States for its support of Israel during the Arab-Israeli War.

Ultimately, OPEC's ability to manipulate market prices is limited, since oil is a readily fungible commodity—that is, it is traded internationally and its U.S. price depends not only on domestic supply and demand, but also on foreign supply and demand. Moreover, its power is further limited because many of the largest oil-producing countries—such as the United States, Russia, Mexico and Norway—are not OPEC members.

Nevertheless, the cartel has considerable influence on crude oil prices simply because OPEC countries control roughly 40 percent of world production. But OPEC is not the only reason for increased volatility of world energy prices during the past 30 years or so. Another possible reason is the deregulation of U.S. energy markets in the late 1970s and early 1980s. Because price determination is now largely a function of market forces, economic or political developments can sometimes engender wide swings in oil prices if markets are caught unaware.

A salient feature of most oil price shocks since the 1970s has been a change in the amount of oil supplied, or the expectation of a disruption in the oil supply (such as during the Gulf War). But oil price shocks can also occur when the demand for oil rises or falls relative to the supply.1 Indeed, the price of imported oil plummeted to below $10 a barrel in late 1998 because of a marked slowing in the growth of world oil consumption—reflecting, importantly, the significant declines in economic activity in South-east Asia. Even though the subsequent run-up in prices during the past two years occurred while OPEC was trying to limit output to boost prices, steadily faster rates of worldwide economic growth suggest that demand-side influences have also been important in pushing up the price of oil.

Forecasting the future pace of real GDP growth is a high-risk venture even in the best of times. But when the economy is hit with an oil price shock and a modestly restrictive monetary policy, the degree of difficulty increases by several magnitudes. At present, higher energy prices seem not to have rattled consumer confidence. This could obviously change if events take a turn for the unexpected or, as government forecasters expect, household energy expenditures climb markedly higher this winter than they did during last year's relatively benign winter. And whereas the cost structure of firms in industries that are fairly intensive users of energy, like manufacturers, transportation firms and agriculture, also tend to be hit disproportionately when energy prices turn higher, most firms—and by extension, the U.S. economy—have managed to cope with the latest oil price shock rather well.

In view of this development, is there something fundamentally different in the structure of the economy that explains this development, or have policy-makers, particularly the Federal Reserve, done a better job of coping with the current oil price shock?