EconSouth (Third Quarter 2002)


The Impact of Oil Prices On Economic Activity

The price for west Texas intermediate crude oil was over $27 per barrel at the beginning of August 2002, representing a 245 percent increase in less than four years. At the end of 1998, by comparison, the same crude was around $11 per barrel. Market price projections reveal that oil prices are not expected to decline much over the next few months.

Oil price increases in recent memory
Sustained increases in energy prices are troubling because history shows that they can have a dramatic impact on the production decisions of firms and the consumption decisions of households. The Arab-Israeli War of 1973, the 1978 Iranian Revolution, the 1980 Iran-Iraq War and the 1990 Gulf War, for instance, were followed by an immediate drop of 7 to 9 percent in the world oil supply. The resulting mismatches between supply and demand led to increasing oil prices. This development, in turn, curtailed economic activity in the United States as a larger share of consumers’ household incomes were diverted away from discretionary expenditures and toward energy consumption. What’s more, the higher costs of production in many cases translated into higher prices for goods and services.

Photo of John Robertson

Different times, different circumstances
But there are some important differences between the earlier incidences of rising oil prices and the more recent episodes. For one, in the 1970s unprecedented oil price increases were associated with large and persistent upswings in the overall rate of price inflation in the economy. In the 1990s it was a different story. Even though the Gulf War brought about a nearly 8 percent drop in the world oil supply, the resulting rise in oil prices did not have any persistent effect on the overall inflation rate. Measured inflation had actually tracked down during the 1980s prior to the Gulf War, and this trend continued once oil prices stabilized in 1991 after the war.

In 1999 the rise in oil prices associated with OPEC (Organization of Petroleum Exporting Countries) production cuts, amounting to about a 4 percent fall in world production, was largely an attempt by OPEC to increase revenue in the face of high and strongly growing demand. Similarly, the decline in oil prices during 2001 reflected weaker world demand and OPEC’s reluctance to jeopardize revenues by cutting production. In both cases the impact on inflation and inflation expectations was relatively minor. Measured inflation changed in the short term, but these developments have not significantly altered the outlook for low, stable inflation.

One possible explanation for the differing inflationary outcomes between the 1970s and the 1990s is a change in the monetary policy response in the face of oil price shocks. Many economists have argued that in the 1970s the Federal Reserve tried to counter the negative impacts of the oil price shocks on economic activity by adopting an expansionary monetary policy stance. This policy may have inadvertently provided a stimulus to inflation — stimulus that persisted for a considerable time. Monetary policy has become less accommodating of oil price shocks since then, suggesting that concerns about an upturn in oil’s relative price are more likely to center on the increase’s effect on real economic activity than on implications for the longer-term inflation outlook.

By John Robertson, assistant vice president of the regional research group
of the Federal Reserve Bank of Atlanta

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