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Economic SYNOPSES short essays and reports on the economic issues of the day 2005 ■ Number 10 Has the Bond Market Forgotten Oil? David C. Wheelock he financial press often links daily activity in financial investors that even a large increase in the price of oil will not markets to general economic news. As of late, the world have a substantial impact on the long-run rate of inflation. The U.S. economy was just beginning to emerge from a price of oil has been one of the most often cited causes recession when the price of oil began to rise in late 2001. Inflaof fluctuations in securities prices. Rising oil prices have been tion was low and, unlike most recoveries, payroll employment blamed for declining stock prices, weakness in the dollar failed to grow. Few analysts viewed inflation as a threat and, exchange rate, and, to some extent, movements in government as employment continued to lag, a few warned that deflation bond yields. Still, compared with other periods of rising oil was possible. In this environment, government security yields prices, the bond market’s reaction has been limited. remained low. Since the oil crises of the 1970s, the yields on government More recently, employment growth has resumed and deflasecurities have typically risen when the price of oil has risen, tion fears have evaporated. However, the rising price of oil is and fallen when the price of oil has fallen. In the 1970s, a risstill not widely viewed as a precursor to higher inflation. In ing price of oil often presaged a sustained increase in the rate part, this could reflect the fact that U.S. firms are more energy of inflation; bond investors responded by demanding higher efficient than they were in the 1970s. Many analysts also believe nominal yields to protect their real returns. Similarly, in the that the price of oil will decline from its recent high level. In 1980s and 1990s, when oil prices and inflation generally fell, addition, however, many commentators argue that the Federal bond yields also fell. Reserve is unlikely to allow higher energy prices to result in a The chart illustrates the positive long-run correlation sustained increase in the rate of inflation. When the price of between the price of oil and government security yields from oil rose in the 1970s, the Fed failed to tighten monetary policy the 1970s through the 1990s. Alongside the price of oil, the sufficiently to prevent higher inflation and bond yields. The chart shows the yield on 10-year U.S. Treasury securities. To importance of maintaining a stable price level is much more highlight longer-term relationships, both series are plotted as widely recognized today than in the 1970s, and the bond mareight-quarter moving averages, which smoothes out short-run ket has considerable faith that the Fed will not allow inflation fluctuations in the data. to rise (or fall) significantly from its present level. As long as The chart also illustrates that the yield on government such faith persists, the price of oil can rise and fall without securities trended downward between 2001 and 2004, even causing large movements in bond yields. ■ as the price of oil more the doubled, and offers a clue for this unusual pattern: The increase in the price of oil was not accompanied by a significant increase in the overall Oil Prices, Government Security Yields, and Inflation, 1970-2004 rate of inflation (shown here as the eight-quarter moving Percent Annual Rate Dollars per Barrel average of the year-over-year percent change in the con40 16 sumer price index). Oil Price (left scale) 14 Security Yield (right scale) The price of oil hit its recent low in December 1998 Inflation Rate (right scale) 12 30 and has risen almost continuously since December 2001. While the increase in the price of oil in 1999 and 2000 was 10 accompanied by a modest increase in bond yields and 8 20 consumer price inflation, the increase that began in 2001 6 has had little or no perceptible effect on either bond 4 10 yields or inflation. The current lack of a response of bond 2 yields to the rising price of oil probably reflects both the 0 0 overall condition of the U.S. economy when the price of 1970 1974 1978 1982 1986 1990 1994 1998 2002 oil began to rise and confidence on the part of bond T Views expressed do not necessarily reflect official positions of the Federal Reserve System. research.stlouisfed.org
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