Rising Oil Prices and Economic Turmoil

By Kliesen, Kevin L. | Regional Economist, January 2001 | Go to article overview

Rising Oil Prices and Economic Turmoil


Kliesen, Kevin L., Regional Economist


MUST THEY ALWAYS GO HAND IN HAND?

After falling sharply during the Asian financial crisis in late 1998, market prices of crude oil and other energy products climbed in November 2000 to their highest levels since the Gulf War. The oil price shock, as economists have coined it, occurred as monetary policy-makers acted to keep the economy from overheating. This combination of events has raised a few red flags in certain quarters, since nearly all post-World War II recessions were preceded by higher oil prices and a restrictive monetary policy. Unlike other oil price shocks since the 1970s, however, the current run-up in energy prices has not yet raised the alarm one might have expected. Indeed, while the pace of U.S. economic activity appeared to slip noticeably during the fourth quarter of 2000, most forecasters continue to project solid growth and moderate inflation for the next two years. Is the U.S. economy better positioned today to withstand the body blows of sharply higher oil prices than it was in the past?

Oil Price Shocks in U.S. Economic History

An oil price shock is one of several possible disturbances to a country's aggregate price level. Its significance reflects the fact that crude oil is an important energy source for most industrialized countries, who use energy as a direct or indirect input in the production of most goods and services. Because higher oil prices tend to raise the prices of petroleumbased products and alternative sources of energy, such as natural gas, the aggregate price level will rise unless the prices of all other goods and services fall to offset the rise in oil prices. Of course, oil price shocks are not always one-sided. Prices of crude oil can also fall in significant fashion, as they did in 1986 and 1998. On balance, though, the public and policy-makers tend to think of oil price shocks as energy price increases, hence, the adverse connotation.

In the early post-World War II period, the run-up in energy prices prior to economic downturns was comparatively mild. During the four quarters preceding the onset of the 1948-49, 1953-54, 1957-58, 1960-61 and 1969-70 contractions, the relative (real) price of energy increased a little more than 1.5 percent, on average. These increases, however, were tempered by the fact that the relative price of energy actually declined 2.4 percent and 1 percent prior to the 1960-61 and 1969-70 contractions, respectively-though energy prices subsequently rose sharply in the midst of these two recessions.

The figure below shows that energy price changes have been much more pronounced (relative to output prices) since the early 1970s. The average increase in real energy prices prior to the onset of the four recessions during this period-1973-75,1980,1981-82 and 1990-91-was 17.5 percent, much greater than in earlier recessions. Except for the 1990-91 recession, one of the mildest since World War II, the contractions of the 1970s and 1980s were the deepest since the Great Depression. Though U.S. economic growth remained solid through the third quarter of 2000, the 23 percent increase in real oil prices from four quarters earlier is nevertheless large in historical terms.

One reason why oil prices have been more volatile since the 1970s has been the advent of the Organization of Petroleum Exporting Countries (OPEC). Economically, OPEC is a cartel-a type of oligopoly that attempts to keep prices above their competitive levels by actively adjusting crude oil supplies. Last year, for example, OPEC oil ministers announced that they intended to alter production to keep the market price of crude oil between $22 and $28 a barrel. OPEC has also tried to manipulate prices for political reasons. The bestknown example was the 1973 Arab oil "embargo," which sought to punish the United States for its support of Israel during the Arab-Israeli War.

Ultimately, OPEC's ability to manipulate market prices is limited, since oil is a readily fungible commodity-that is, it is traded internationally and its U. …

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