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July 1, 1983
OPEC,Inflation,andMonetaryPolicy
The recent declines in energy prices will
have important effects on the economy. In
this Letter, their impact on output, inflation,
and interest rates will be addressed along
with their implications for monetary policy.
A decline in energy prices reduces the usefulness of the money supply and interest
rates as indicators of future ,Inflation and
output, but as we will show, it simultaneously provides monetary policy with a wider
menu.of macroeconomic outcomes from
which to choose.
Fuel price declines
At its Winter conference, OPEC officially
agreed for the first time to reduce the price of
its Saudi marker crude oil. The five-dollar
reduction to twenty-nine dollars per barrel,
along with similar price cuts in other categories of OPEC oil, contrasts sharply with
the experience of the last decade when
posted oil prices rose dramatically. The solid
line in Chart 1 plots the percentage change
of an index of real energy prices, that is, the
ratio of energy prices to the aggregate level
of prices of all goods and services. This
producer price index forfuel and power
includes the prices of gasoline, heating
fuels, natural gas, and electricity.
In the two decades before 1973, the frequent
negative values shown by the solid line
meant a decline in real energy prices of
nearly twenty percent. Relative energy
prices then reversed course, rising sharply
in the middle and again in the late 1970s.
Although the recent declines in energy
prices are not negligible, they pale in comparison to the increases brought about by
the quadrupling and subsequentdoublingof
oil prices associated with OPEC-1 in 1974
and OPEC-2 in 1979.
Chart 1 also shows the percentage change in
the aggregate price level, as measured by the
G N P deflator. Risesand falls in this measure
of inflation, especially in the 1970s, tend to
be positively associated with rises and falls
in real energy-price growth.
We compare the course of energy costs with
an indicator of the economy's strength by
comparing the index of real energy prices
with the level of unemployment in Chart2.
The chart shows that large increases in the
unemployment rate came on the heels of the
steep rises in energy prices that occurred in
the 1970s. It is generally believed that the
large oil price increases were an important
cause of the subsequent increases in unemployment and in the rate of inflation. The
question naturally arises, then, whether the
recent negative oil price shock will lower
unemployment and inflation.
.
lower inflation
Lower energy prices contribute directly and
indirectly to lower inflation. Fully one-third
of the twelve percentage point decline in
consumer price inflation that occurred
between the late 1970s and the six-month
period ending February of this year is due
directly to lower energy prices because the
price of energy is a component of the
Consumer Price Index. This happened
despite the large increase in. natural gas
prices that accompanied their deregulation.
The fall in energy prices also reduces the
cost of producing many products and
thereby reduces inflation indirectly. These
reductions "percolate" through various
stagesof the production process, finally
showing up in the cost of finished goods.
The effect on final prices is greatest for the
output of industries that are more energyintensive, such as chemicals and metals.
A perhaps more important indirect effect is
that of lower energy prices on labor costs.
Cost-of-living-adjustment (COLA) clauses in
many existing labor contracts partially tie
wage increases to recent price changes.
Even where workers are not covered by
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late business investment in new plant and
equipment At the same time, real government expenditure is also likely to rise above
what was previously contemplated as the
same dollar amount of expenditures would
now go further.
COLAs, wage and salary negotiations often
take recent price increases into account.
Because labor costs constitute two-thirds of
total production costs, the feedback effect of
lower energy costs on wage increases can be
important It can also occur fairly rapidly
since about half of workers covered by
COLAs in major agreements have their
wages adjusted quarterly while most of the
other half, and most non-union workers,
have their wages adjusted annually.
Misleading money indicators
Although lower oi I prices are generally good
for the economy, they may alter the shortrun relationship of the money supply to
prices and to output Monetary aggregates
are used by the Federal Reserveas a guide to
monetary policy because of their relation to
income and spending, Large changes in oil
prices, however, may reduce the aggregates'
value to making monetary policy because
oil price declines may lead to.lower.inflation""
and higher output than would othelWise
emerge even with no change in money
growth or in the growth of nominal income,
A model of the economy developed by the
Department of Commerce suggests that
wage growth slows by approximately half as
much as the inflation rate after only one
year. Over the longer run, the model suggeststhat wage growth slows by about the
same amount as the inflation rate. Thus, a
pronounced oil price decline is capable of
having a sizeable impact on wage growth,
And since wage growth is an important
determinant of the underlying, or core,
inflation rate, oil price declines may lead
to lower inflation rates over the longer run
as well.
Unfortunately, changes in oil prices may
also reduce the value of interest rates as
economic indicators. Because nominal
interest rates consist of a real rate and an
inflation premium, theirreaction to lower oil
prices must be studied in two parts, To the
extent that current inflation weighs heavily
in determining the inflation rate expected in
the near future, slowing inflation will reduce
the inflation premium and thereby, nominal
rates. Lower prices will also increase the real
supplies of money and credit (at given nominal growth rates), and thereby put downward pressure on real interest rates. The
decline in real rates, however, may be partially offset by the effect of increased investment directly associated with lower energy
prices, A sufficiently strong investment
response means a greater demand for investment monies that could result in a higher
(than othelWise) real interest rate. In the
wake of lower oil prices, then, the net
change in real and nominal rates is
ambiguous,
Higher output
Lower energy prices are likely to strengthen
real demand by households, business, and
government Business will increase production to satisfy increased real volumes of
sales, and, in the process, use more of the
economy's resources (including labor).
Eventually, it will reduce unemployment
Households will spend less of their income
on foreign oil and have more left to spend on
domestically produced 9utput Lower
energy prices will increase consumers' total
real spending power since wages and salaries will often fall at a slower rate than
overall consumer prices in the near-term,
Over the longer term, real wages will be
higher than othelWise because business will
have increased its use of capital and energy
in production and thereby enhanced labor
productivity,
Thus, even with unchanged money supply
growth, we may see either higher or lower
real nominal interest rates associated with
Greater consumer demand for business
products and lower energy costs will stimu2
Chart 2:
FUEL PRICES AND UNEMPLOYMENT
Chart 1:
FUEL PRICES AND INFLATION
Chllnga {%j
,
OPEC-1
4'
,
OPEC-2
Change {"!oj
40
40
3.
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OPEC-1
4.
Fuel Price .;. GNP Deflator
30
......Fue! Price.;. GNP Deflalor"
3.
,
30
2.
2'
20
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20
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10
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,f
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•o
GNP Deflator
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,97
higher output. Neither real nor nominal
interest rate movements alone would signal
the easing or tightening of monetary policy_
The movements also would not tell whether
future output will be higher or lower.
NRste
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1970s. In the last decade, various factors
constrained the rise in inflation. Consumer
real demand was restrained by substantial
reductions in both real wages and real financial wealth when oil prices rose in the early
1970s. Nominal wages responded slowly to
higher prices, and regulatory ceilings on
nominal interest rates effectively produced
negative real returns on important assets,
Moreover, output may rise even if money
growth slows moderately in response to the
lower oil prices. High real interest rates are
believed to have slowed the
economy
over the past few years. However, wh ile
some view the current high real rates to be
an impediment to vigorous recovery, the
recent energy price declines suggest that
recovery may start with historically high real
interest rates and continue with both output
and real rates rising. I f investment rises due
to energy price declines, rising rates may be
signalling stronger credit demand and not
only weak supplies.
u.s.
Today, inflation may be more responsive to
oil shocks. The deregulation of financial
institutions and the shorter length of private
sector labor contracts may have speeded the
economy's responsiveness to shocks. With
the advent of new financial instruments, real
assetreturns are kept closer to market levels.
Wages and the prices in deregulated industries such as transportation may now
respond more quickly.
M onetary policy options
The sharp increase in energy prices in the
1970s presented monetary policymakers
with a fundamentally new policy problem:
Simultaneously rising inflation and unem. ployment. Lower oi I prices, as we have
shown, could mean lower inflation and
higher output than otherwise even if monetary policy remains unchanged.
These changes suggest that, in response to a
positive supply shock such as a sharp drop in
energy prices, real wages may not rise as
much now as they fell during the 1970s. To
the extent that market rates were already
being earned on assetsbefore the latest oil
price decline, real returns will probably not
rise now the way they fell a decade ago. As a
result, such increased flexibility would
generate greater inflation reduction (and
larger output gain) than previous experience
wou ld have suggested.
Lower oil prices reduce the inflation rate
during the transition period marked by the
reverberation of falling prices throughout
the economy. Once a new price level is
attained, an inflation rate closer to the
underlying rate will be re-established. I nflation at this core rate is largely determined
by growth in labor compensation and wil l
dominate over the intermediate-run, as i tdid
between 1 976 and 1978. In the shorter run,
consumer price inflation may fall dramatically because energy costs and nomin al interest rates make up a large part of consumption expenditures.
In sum, the current shock offers the chance
to lower the underlying inflation rate. The
prospects for so doing may be even greater
with a drawn-out, moderate inflation reduction than with a sharp drop and subsequent
rebound. I f so, temporarily faster money
growth may be desirable both because itwil l
hasten the economy's recovery and because
it wi II lessen the current downward pressure
on inflation. Later, money growth must be
slowed to achieve a lower underlying inflati.on rate.
JamesA. Wilcox
However, the economy's response to the
positive oil supply shock of the early 1980s
may not be a simple, scaled-down mirror
image of the negative shock of the early
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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amountsin millions)
SelectedAssetsand Liabilities
large Commercial Banks
loans (gross,adjusted)and investments'"
Loans(gross,adjusted)- total#
Commercialandindustrial
Realestate
. Loans to individuals
Securities loans
U,S. Treasury securities'"
Other securities'"
Demanddeposits- total#
Demanddeposits- adjusted
Savingsdeposits- totaH
Time deposits- total#
IndiViduals,part.& corp.
(large negotiable CD's)
WeeklyAverages
of Daily figures
Member BankReservePosition
Excess Reserves(+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( -)
Amount
Outstanding
6/15/83
162,856
141,346
44,142
56,200
23,730
2,659
8,257
13,252
44,138
30,336
67,191
64,274
58,148
17,992
Weekended
6/15/83
116
641
525
Change
from
6/8/83
Change from
year ago
Dollar
Percent
- 260
-
107
- 202
39
50
- 197
42
- 196
3,024
922
- 382
- 113 48
- 229
Weekended
6/8/83
2,958
2,238
665
1,123
399
502
1,726
1,006
4,124
2,925
36,290
31,139
27,560
17132
-
-
-
1.8
1.6
1.5
2.0
1.7
23.3
26.4
7.1
10.3
10.7
117.4
32.6
32.2
48.8
Comparable
neriod
147
72
75
29
8
21
* Excludes trading account securities.
# Includes items not shown separately.
t Includes Money Market Deposit Accounts, Super-NOW accounts, and N OW accounts.
Editorialcommentsmaybeaddressed
to theeditor(GregoryTong)or to theauthor•... Freecopiesof
this andother federal Reservepublicationscanbe obtainedby callingor writing the PublicInformation Section,FederalReserveBankof Sanfrancisco,P.O. Box7702,SanFrancisco94120.Phone(415)
974-2246.
.
@FedFRASER