High Oil Prices Could Constrain Monetary Policy

by: Ryan Avent

One other thing to mention about the threat from high oil prices — they may constrain monetary policy. In a recent post, James Hamilton noted that many economists have argued in favor of a positive, and perhaps elevated, rate of inflation as a means of boosting the economy. Hamilton says that this position derives from a typically stripped down economic model in which inflation affects all goods equally. In fact, inflation tends not to work like that. Instead, relative prices shift, which can be extremely destabilizing. That, he says, is what happened last summer, as low interest rates fueled a commodities boom that tripped up a shake economy.

Hamilton links to an old post of his, from February of 2008 — one I recall reading and commenting on at the time. In the light of hindsight, it’s a remarkable piece of analysis:

Some analysts are saying that Fed Chair Ben Bernanke is walking a tightrope– if he does not drop interest rates quickly enough, the U.S. will be in recession, but if he goes too far, we’ll see a resurgence of inflation. I am increasingly persuaded that’s not an accurate description of the situation…

If it were just a few commodities moving, I wouldn’t be concerned, as any of these prices can be quite sensitive to small disruptions in supply. But we are clearly looking at an aggregate phenomenon here, and it seems unreasonable to suppose that the phenomenon has nothing to do with choices by the Fed. Although I have been skeptical of Jeff Frankel’s story that low interest rates were the primary cause of the broad movements in commodity prices over the last several years, it is very plausible to me as one explanation of what we’ve seen happen over the last two months…

The monetary cure for our ails of course also has a downside, in that we’ll later need an artificial recession to bring the inflation back down. Greg Mankiw notes Allan Meltzer’s displeasure at this prospect:

A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public’s complaints about inflation.

I agree with Meltzer that the recent Fed rate cuts are buying us higher output at the moment at the cost of lower output in the future, for just the reason Meltzer gives. But I disagree that the recession Bernanke is trying to avoid would be a “small” one. The Fed chief must be worried that a recession in the present instance would precipitate major financial instability, in which case perhaps the choice between paying now and paying later argues in favor of latter.

To recap, Hamilton believes Bernanke is rapidly easing because a recession in early 2008 would have precipitated major financial instability. Critics, like Meltzer, argued that Bernanke shouldn’t be easing so much, since rapid easing might generate major inflation, which would create the need for a major disinflationary recession down the road. What ended up happening was that lopsided inflation — the commodities boom — triggered financial instability. Everyone was right and everyone was wrong.

What this suggests is that if Bernanke has learned his lesson, then he will tolerate less of an increase in commodities prices now than he would have previously, when he was more focused on movements in core prices.

(Side note: if you go one link deeper into Hamilton’s archives, you arrive at this post, from 2006, in which it appears that copper and aluminum futures perfectly predict the path of the economy through this spring.)