Higher Oil Prices Could Lead to Higher Overall and Core Inflation Rates: St. Louis Fed Analysis

Article excerpt

Although the price of petroleum has moderated recently, a permanent increase to $150 per barrel by the end of 2008 could have a significant negative effect on the rate of real gross domestic product (GDP), at least in the short run, based on an analysis from the Federal Reserve Bank of St. Louis.

Kevin Kliesen, an economist with the St. Louis Fed, analyzed the price of oil and the U.S. macro-economy for the September/ October issue of Review, the Reserve Bank's bi-monthly journal of economic and business issues. The publication is also available online at the St. Louis Fed's website: http://research. stlouisfed.org/publications/review.

Nearly all post-World War II recessions in the United States were preceded or accompanied by an increase in oil prices, which is why oil price shocks are viewed with alarm by forecasters, macroeconomists, financial market players, and public policymakers. "An oil price shock," Kliesen explained, "is typically a large, unexpected increase in the relative price of energy that affects the economic decisions of firms and households."

An oil price increase may lower real GDP through several channels. For one, higher prices raise uncertainty about future oil prices and, thus, can cause delays in business investment. Second, dramatic oil price changes induce "resource reallocation," such as the major automakers switching production from trucks and SUVs to smaller cars and hybrids.

Kliesen said that estimates of the short-run macroeconomic effects of higher oil prices on real GDP growth can vary. Employing a simple forecasting exercise based on an augmented version of a well-known economic model that explains changes in real GDP growth based on changes in oil prices, he found that an additional $50-per-barrel increase in the price of crude oil would cut real GDP growth by about 0. …