Oil price shocks are not, at first glance, a complicated economic event to analyze: price shocks increase the cost of living for those who must consume oil that they don’t own. It really is that simple. And an increase in the cost of getting by, as it was known where I grew up, is axiomatically a reduction in the standard of living for such folks: American workers driving to work in America, a country that consumes more oil than it produces.

And they don’t like it. After paying up for petrol, they have less purchasing power left from their paychecks to buy other things. In this sense, the oil price shock is similar to a tax hike, as the cliché goes. Indeed it is. Tax hikes are negative for economy-wide aggregate demand for non-oil expenditures, particularly tax hikes of a regressive nature, as an oil price shock is. Concurrently, inflation arithmetically goes up, as the weighted average increase in oil prices swamps any weight-averaged softening in non-oil prices associated with weakened demand. So, an oil price shock is a tax hike with stagflationary consequences. Nasty stuff.

It’s sad, and it’s unfortunate. But it’s also basic economics: an increase in the price of a good that you consume but don’t produce relative to the price of goods that you do produce is technically called a negative terms of trade shock. Less technically, it’s similar to being told by your father-in-law that in honor of your mother-in-law’s outrageously good scalloped potatoes at Thanksgiving, you will be expected to bring two bottles of fine wine this year, not one as you did last year. The price of those spuds just doubled. And you gotta have them!

What Is Is

But not every day, only one day a year. In contrast, you gotta drive to work every day. And so do other Americans, who collectively consume more petroleum than America produces, with the balance coming from imports. Accordingly, there is no getting ‘round the reality that an oil price shock is a negative terms of trade shock for America and a positive terms of trade shock for those who export oil to us.

Yes, it is true, as many argue, that such a shock is not as severe today as it was three decades ago, as energy per unit of GDP has declined. It probably is true that being hit over the head with a 16-inch baseball bat is less painful than being hit over the head with a 32-inch baseball bat. But only a fool would argue that taking a hit from a baseball bat is not a negative shock. Which brings us to the issue of how the present oil price shock will be defused: slower growth, higher inflation, or both?

The easy answer is: both. The tougher answer is: it depends. Yes, I know that’s always the economist’s fudge, forever saying that everything depends on everything else. But that does not make it any less true in the case of the aftermath of an oil price shock. How the Fed responds or doesn’t, and the impact of that response or non- response, will depend critically on the Fed’s assessment, and then the reality, of how the negative real shock is defused. More specifically: do the losers try to get even?

Returning to the saga of the second bottle of wine you delivered to your pops-in-law, does he put it in his cellar, or do you insist on drinking it at Thanksgiving dinner? If he puts it in his cellar, then there has been a one-time shift in wealth from you to him. If you had planned to drink it before giving it to him, and are budget constrained, then there has also been a one-time downward adjustment in your consumption, a one-time blip upward in the economy-wide savings rate, a one-time upward adjustment in economy-wide inventories and, presumably, a one-time downward adjustment in the wine producers’ output, since your budget constraint prevents you from replacing the wine that you would have drunk but didn’t, because it is now in pops-in-law’s cellar. Once all these adjustments are complete, life goes on as before.

But suppose you don’t really want to cut your wine consumption and insist that the second bottle be opened at Thanksgiving dinner. In that case, consumption doesn’t change but the timing of it does: the wine you drink at dinner is wine that you can’t drink tomorrow, since you are income constrained, consumption is simply accelerated; inflation will pop upward today, as you’ve included very expensive scalloped potatoes in your chain-weighted personal consumption basket, but there will be no scalloped potatoes at all in your consumption basket tomorrow. And day after tomorrow, life will go on as before. No body’s standard of living will have changed: there has simply been a one-time wealth transfer from you to your father-in-law: he got to consume wine at Thanksgiving dinner that you would have consumed the next day, but didn’t, because you are budget constrained.

But, let’s say you carry a grudge about this and decide to get even. It just so happens that you are having the in-laws over to your house the day after Thanksgiving. You declare that the price for your wife’s outrageously good coconut cream pie has doubled: pops-in-law must bring you two, not just one, of those fine cigars from his humidor, the ones that you love but don’t regularly consume, given your budget constraint. In this outcome, inflation does not just go up on Thanksgiving but on the day afterward, too: a one-time price shock for scalloped potatoes has spilled over into a second price shock for coconut cream pie.

And since your father-in-law is not budget constrained, he replaces in his humidor the extra cigar that would not otherwise have been smoked, increasing aggregate demand for cigars, putting upward pressure on their price. Which, of course, imposes a negative real shock on all other budget-constrained cigar smokers, leading them to ask for heftier cost-of-living salary increases from their
employers. Who, in turn, both boost the prices for the goods they sell and fire some workers in an attempt to claw back the negative hit to their real profit margins.

Thus, in the fullness of time, the economy takes on the smell of stagflation, all because (1) your father-in-law imposed a price shock by doubling the price of your mom-in-law’s scalloped potatoes, and in response, (2) you tried to get even with him by doubling the price of your wife’s coconut cream pie. Who would have thunk it?

An oil price shock imposes the same stagflationary risk scenario: rather than a one-time shift in wealth from net oil consumers to net oil producers, net consumers might deny reality and try to even the score. But the score cannot be evened: what is is, as former President Clinton might say, as what is is that an oil price shock puts net importers of oil on a permanently lower growth trajectory for real standards of living.

Conceptually, and in the long run, the growth trajectory for the real standard of living for oil importers and oil exporters together need not be lower, just the distribution of their aggregate welfare. But as Keynes intoned long ago, in the long run, we are all dead. More relevant, he also noted that:

“....the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

Which brings us to the matter of how the Fed should respond to today’s oil price shock. Conventional wisdom at the Fed is that policy makers can be chilled about the inflationary impact of the oil price shock if those that are negatively shocked will just take their hit like real men and women, with (1) producers of non-oil products resisting accelerating price hikes, in attempt to protect their real profit margins and (2) workers resisting demands for heftier cost-of-living salary increases, in an attempt to avoid cutting their real non-oil consumption basket. In contrast, so conventional wisdom goes, the more that producers of non-oil products and workers try to “make themselves whole” for the negative real shock of the oil price shock, the more the Fed should beat them to their senses with tighter monetary policy.

Or, returning to the saga of Thanksgiving dinner, conventional wisdom is that if you try to get even with your father-in-law for doubling the wine-price of scalloped potatoes by doubling the cigar-price of coconut cream pie, Alan Greenspan – aided by Arlo Guthrie’s friend, Alice – should outlaw smoking on the Friday after Thanksgiving.

I’m not so sure. Not that I have an easy solution for the Fed to follow in the wake of an oil price shock. The cold reality is that there are no easy solutions. For a country that is a net importer of oil, an oil price shock is a real phenomenon, not just a price phenomenon. America is simply less well off than before the shock. There is no getting ‘round this reality.

The only issue is how to distribute the pain called stagflation: how much stag versus how much ‘flation? The ultimate form of stag is, of course, a recession. Which, in the fullness time, would cure the ‘flation, but at the risk of generating the other ‘flation called deflation. Again, there ain’t no easy solutions.

Indeed, and ironically, the lower the level of inflation before an oil price shock hits, the more troublesome is the dilemma for the monetary authority. Once a central bank has achieved secular effective price stability, as the Fed declared on May 6, 2003, the concept of an “opportunistic” recession, as part of a secular campaign of “opportunistic disflation” becomes an oxymoron. While recessions opportunistically pay welcome disinflationary dividends when inflation is above the central bank’s long term (implicit, in the case of the Fed) inflation target, recessions un-opportunistically impose the risk, if not the certainty, of unwelcome disinflation once effective price stability has been achieved.

Bottom Line

The Fed does not presently have the flexibility to preemptively tighten so as to “insure” that producers and workers take the real oil price shock lying down. They might, in which case the oil price shock
will be a one-time level adjustment for price indexes and output indexes. It will look like stagflation while those levels are adjusting, but once they’ve completed their adjustment, growth rates for those indexes will return to their status quo ante. And Greenspan will look like he walks on water unfrozen.

Alternatively, producers and workers might “fight back,” as they did in the 1970s, in which case logic implies less nasty stag in the short run but higher ‘flation in the long run. In which case, in the long run, with inflation well above the Fed’s implicit inflation target, the Fed will once again embark on a mission of opportunistic disinflation.

But not here and not now. The Fed is presently embarked on a journey of measured tightening and the oil price shock is not likely to either accelerate or halt that journey. But in the unlikely case that it does, the oil price shock is far more likely to temper the Fed’s tightening impulse rather than to agitate that impulse.

From a starting point of effective price stability, money illusion – otherwise known as fooling most of the people most of the time that paper money is real money – is a necessary lubricant for defusing and distributing real shocks.

Paul A. McCulley
Managing Director
August 25, 2004
mcculley@pimco.com