Does the spike in oil prices presage an economic downturn?
That the Federal Reserve missed the window of opportunity last year to painlessly remove monetary accommodation and initiate monetary tightening has made the current situation particularly dicey. With inflation rates already at 40-year highs, and yet to peak, a stagflationary outcome is hard to rule out.
In the past, recessions were often linked to oil price surges. Oil shocks were associated with the 1973-74 OPEC embargo, the 1978-79 Iranian Revolution, the 1980 Iran-Iraq war and Saddam Hussein’s invasion of Kuwait in 1990. Economist James Hamilton has argued that a spike in oil prices from 2007 to 2008 even contributed to the Great Recession.
Will the current spike in oil prices (U.S. crude oil price rose from around $66 in early December 2021 to around $120 in early March 2022) trigger an economic downturn? To answer the question, it is necessary to consider the multiple channels through which a spike in oil prices will adversely impact the growth of the real economy.
James Hamilton’s seminal research led to a decades-long attempt to discern the macroeconomic effects associated with oil price fluctuations. Asymmetries and shifting responses complicate the task of establishing a clear relationship between oil price volatility and real GDP. The extent to which output is impacted by oil shocks depends, among other factors, on the nature and source of the disturbance, the price dynamics leading up to the shock and the underlying economic conditions that were prevalent prior to the shock.
Past studies have shown that the U.S. economy reacts asymmetrically to oil price fluctuations. Specifically, the adverse or negative economic impact arising from rising oil prices often exceeded the stimulative effect resulting from falling oil prices. Economists have identified both direct and indirect economic effects associated with a sudden (and unexpected) spike in oil prices.
A San Francisco Federal Reserve report summarized the direct impact of high oil prices thus: “When gasoline prices increase, a larger share of households’ budgets is likely to be spent on it, which leaves less to spend on other goods and services. The same goes for businesses whose goods must be shipped from place to place or that use fuel as a major input (such as the airline industry). Higher oil prices tend to make production more expensive for businesses, just as they make it more expensive for households to do the things they normally do.”
An adverse oil price shock can also generate a series of indirect effects. In the real world, capital and labor cannot be reallocated among sectors in a rapid fashion due to the presence of various frictions. If there are costs and/or time delays associated with reallocation of capital and labor, then aggregate demand and output may decline in the short run. For instance, auto manufacturers cannot shift production from gas-guzzling SUVs and pickup trucks to fuel-efficient cars or electric vehicles overnight. The global oil refinery sector offers another illustration of the underlying challenges.
Furthermore, the heightened uncertainty resulting from the oil price shock may cause consumers to postpone purchases of durable goods and firms to delay irreversible investments. Such behavioral changes in aggregate could produce an economic slowdown in the short run.
Another indirect effect associated with a negative oil price shock is related to the central bank’s response. Driven by inflationary concerns, central banks may hike interest rates in response to a surge in oil price and, thus, contribute to a potential slowdown in economic activity. The significance of the indirect monetary channel has been a matter of some debate.
In a 2011 speech, the then-president of the Boston Fed, Eric Rosengren, observed: “If supply shocks tend to have a transitory impact on headline inflation, and do not pass through to any meaningful extent into core inflation, then monetary policy need not respond to the price increases caused by the supply shock.” The Fed’s decision not to act in response to the 2011 oil price shock proved to be a wise move in hindsight.
The impact of the 2022 oil price shock is, however, likely to be more severe. U.S. inflation rates are already at 40-year highs and, unlike 2011, there is not much labor market slack left in the economy. Having fallen behind the curve, the Federal Reserve must engage in a series of interest rate hikes as there is growing evidence that higher prices are becoming embedded and are being fully incorporated in the decisionmaking of U.S. firms.
Until the Russian invasion of Ukraine, American consumers appeared willing to tolerate higher prices and maintain their robust spending levels. But the geopolitical shock emanating from Eastern Europe and the resultant spike in food and energy prices may finally lead to some demand destruction. Rising financial market volatility and decline in asset values may further crimp household spending.
Wide-ranging sanctions imposed on Russia and fresh supply chain disruptions are likely to create a heightened degree of uncertainty for both domestic and international businesses. If the geopolitical disturbances create lasting and wrenching changes in the global economy, then hopes for a rapid return to normalcy may soon fade.
In the absence of a swift and, hopefully, lasting peace settlement between Ukraine and Russia, and in light of the policy bind facing the Federal Reserve, it is not surprising that the bond market appears to be signaling a hard landing for the U.S. economy.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.