Craig Eisele on …..

February 27, 2012

When the supply shocks are demand shocks and the demand shocks are supply shocks

Filed under: Uncategorized — Mr. Craig @ 12:22 am

MATT YGLESIAS muses on the threat of oil prices to the American economy:

As Michael Levi writes we’ve traditionally wanted to distinguish between supply shocks and demand shocks as drivers of price spikes. When oil gets expensive because of a supply disruption, that hurts America. But when oil gets expensive because there’s lots of demand and economic growth, that’s just a sign of growth…

For things to go wrong for the U.S. economy something else has to go wrong over and above the oil. We can see what those “somethings” might be, related to exchange rate issues or the failure of the US government to issue a quantity of bonds commensurate to global demand. But it looks to me as if a demand-side oil issue is really just the same old issue of the trade deficit and the international balance of payments and not the second coming of a 1970s-style oil price shock. Perhaps it’s a monetary policy issue…The chain will only be broken here if the Fed decides to ignore its own self-guidance and target headline inflation instead of core inflation.

We need to be careful here, in a few different ways. First, one can talk about different fundamental changes in oil markets that potentially contribute to economic activity in different ways. For instance, there might be a shortfall in oil production generated solely by action that results in pipes that had been running full to run dry. Or there might be secular stagnation in oil supply. Or there might be a rise in price generated by rapid growth in global demand. Or their could be an oil-specific increase in demand prompted by concerns about the stability of future supply. These changes are likely to impact the American economy in different ways, but it’s sure to be tricky to pull apart the different oil-market causes (political supply shocks might well occur alongside global demand growth and precautionary demand growth), and trickier still to separate out oil-market causes from other shifts in the global economy. Rising oil prices generated by increasing global demand could be relatively benign while precautionary demand growth might be less so, but what if the first leads to the second? In practice, there is less agreement among economists about how differently oil-supply and oil-demand shocks affect the economy than we might hope for. While some argue that demand-driven spikes are less problematic, others, like James Hamilton, have written that the spike of 2007-08 had an impact very similar to that associated with the more political shocks of earlier eras.

Second, we also need to note that rising oil prices represent both demand shocks and supply shocks to the American economy. Dear oil can impact demand directly, by reducing real household income, and indirectly, by influencing consumer confidence. If rising oil prices were purely a problem of demand, then the only thing to fear would indeed be fear itself—by households or by overactive central banks. They are not, however. Soaring oil prices can also dent an economy’s productive capacity. America relies on petroleum as an input to production in lots of different ways—directly, in the case of things like chemicals and plastics, indirectly, in the role oil plays in supply chains and labour markets (as in commuting). When oil prices spike some American production becomes uneconomic. Were the central bank to treat this disruption as a purely demand-oriented phenomenon, it would generate lots of inflation without returning the economy to its previous output peak. For this reason, central banks tend to approach oil spikes by taking some of the hit in inflation and some in reduced growth (admittedly, they may opt for too much of the latter relative to the former).

The hit to supply needn’t be permanent. The spike may dissipate. Or production patterns may adjust such that the American economy can return to its previous potential path at a lower oil intensity. If we’re concerned about the effect of this latest price rise on the American economy, we need to be concerned about lots of things—the nature of the shock, its size and persistence, and the policy reaction—but also on whether firm and household behaviour has changed in recent years to adapt better to big increases in the cost of oil.

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