Thursday, March 24, 2016

Why Declining Oil Prices Can Be Contractionary

Maury Obstfeld et al., writing on the IMF’s blog site, don’t do a very aggressive job of advertising their main observation, so let me do it here.

The problem is that you’d think that the decline in global oil prices since 2014 would be a net plus for the world economy, in the same way that the price spikes of the 70s were a (big) net minus.  That’s not what we’re seeing, however.  Overall, it’s a wash or possibly a slight negative, even if we don’t read too much into the link between oil and stock prices.  You might argue reverse causation, that it’s the slack in the economy that’s pulling down oil and other commodity prices, and there’s some truth in this, but, as Obstfeld and his coauthors point out, econometric studies have put most of the explanation for the price drop on increases in supply rather than reductions in demand.  So what gives?

Their point is simple but important.  Monetary policy throughout most of the developed world has been stuck at the zero lower bound, despite recent forays into negative rates for some instruments.  Under this circumstance, declines in the price level translate into perverse increases in real interest rates, and our IMF sources provide evidence that oil prices are moving in step with inflation expectations:

The bottom line (which they fudge around a bit) is that monetary policy really, really needs help.  Fiscal expansion is essential.


Peter said...

I'm all for fiscal action. I think it works better than monetary policy.

Still many economists are being dishonest when they say monetary policy is spent. As Kocherlakota (today) Dean Baker and many other economists are arguing, the central bank could do more if it had the will.

It's bizarre to argue that monetary policy isn't working when they're tightening.

Peter said...

"Even though oil is a less important production input than it was three decades ago, that reasoning should work in reverse when oil prices fall, leading to lower production costs, more hiring, and reduced inflation. But this channel causes a problem when central banks cannot lower interest rates. Because the policy interest rate cannot fall further, the decline in inflation (actual and expected) owing to lower production costs raises the real rate of interest, compressing demand and very possibly stifling any increase in output and employment. Indeed, those aggregates may both actually fall. Something like this may be going on at the present time in some economies. Chart 3 is suggestive of a depressing effect of low expected oil prices on expected inflation: it shows the strong recent direct relationship between U.S. oil futures prices and a market-based measure of long-term inflation expectations."

The Fed is failing to keep inflation expectations up with an assist from Congress.

john c. halasz said...

You missed another key point for a contractionary effect of the oil price crash: declining investment spending. The oil and gas sector has been virtually the only sector with robust investment since the 2009 recession, fueled by cheap money from the Fed. (Fracked gas has been below its production cost since 2012.) Now the hedges have worn off, the debts are coming due and the junk spreads are blowing out, with the coming wave of bankruptcies and retrenchments.