Oil Price Shocks
An Appeciation of Felix Salmon

Tim Duy: Commodity Shock


Commodity Shock: How quickly the world can change.  Just a few weeks ago, incoming data suggested room for optimism.... The rapidly evolving situation in the Middle East, however, threatens to unsettle this positive momentum as oil prices surge.  Unfortunately, the suddenly choppy economic waters catch US monetary policymakers off guard, and it shows in recent Fedspeak.  It appears that the Fed is stuck between two narratives, one in which the energy price shock turns inflationary given signs of economic improvement in recent months, and another in which oil undermines a still-nascent recovery.  It is an unfortunate debate to have during this period of uncertainty and this early in the recovery....

I think it is somewhat silly to be discussing an early end to the LSAP as it only adds another layer of uncertainty on what was already an increasingly uncertain environment.  Somewhat pointless as well – the end is fast approaching in any event.   Indeed, I find the debate disappointing, albeit expected.  Policymakers appear to have learned little from their failed exercise in hawkishness this time last year.

What should be our baseline expectation for policy at this juncture?  First, the current LSAP policy concludes as planned, at least in magnitude.  They could choose a more gradual end to the policy, but I am hard pressed to see a change in the ultimate amount given the time horizon (June will come faster than we think).  Indeed, continuing high unemployment alone argues against meaningful alteration of the policy despite signs of economic health.  Second, the oil price shock raises the odds for another round of easing.  Simply put, the recent trajectory of commodity prices threatens to shift the story from a benign signal that the economy is on the mend to something much more dire.  And much more dire generally induces monetary easing, not tightening.

Consider an example I recently used in class.  The question:  What is the impact of a commodity price shock?  To gain some direction, construct a four variable vector autoregression of commodity prices, core PCE prices, real GDP, and the federal funds rate.   For a commodity price measure, I used the PPI measure for Crude Materials for Further Processing.... I estimated the model with 5 quarterly lags over the period 1984:1 to 2010:4.  I then generated impulse response functions.... [A] roughly 8 percentage point increase in commodity prices yields virtually no impact on core inflation, but, after four quarters, drives real GDP growth down .17 percentage points.  Monetary policy responds with a .23 percentage point decrease in the fed funds rates after 7 quarters.  Of course, in the current zero interest rate environment this response would need to be mimicked with a fresh expansion of the quantitative easing (I have yet to find a satisfactory replacement for the federal funds rate to take into account the zero bound.  Topic for future research)....

[W]e are experiencing a significant commodity price shock this quarter.  While certainly a drag on growth, is it yet sufficient to derail the recovery?  The White House thinks no.... “Anything like we have seen so far neither we nor the private sector has forecast that would derail our recovery,” Goolsbee said yesterday at a breakfast with reporters organized by the Christian Science Monitor. I would tend to agree – if commodity price inflation slows sharply at this point.  But the surge of recent weeks has already exceeded my expectations.... The economy can’t withstand another quick run to $140 a barrel, and I suddenly feel that we are at a tipping point to brings such a run into view...