Sunday, September 17, 2006

Another Problem with the Anti-Core Argument

Following up on my previous post, I want to make an empirical point about Caroline Baum’s argument. She argues that a long lag cannot explain the failure of non-oil prices to adjust downward in the face of rising oil prices:
You might counter by saying that the price of something else will fall with a lag, not simultaneously; that when gas prices go up the consumer doesn't immediately cut back on his non-oil purchases.

Let's go to the video tape. The consumer price index was running at about 2 percent year-over-year during the deflation scare in the middle of 2003. Crude oil prices were hovering near $30 a barrel.

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.
But there’s a problem here (beyond the theoretical problems mentioned in my previous post). First of all, nobody disputes that the Fed was accommodating the oil price increases in 2003 and 2004. So it shouldn’t surprise anyone that non-oil prices failed to adjust during 2005 and the first half of 2006. At the time (2003 and 2004), the Fed had legitimate concerns about a soft economy, but the economy subsequently proved to be stronger than the Fed had feared. It turned out that the intentional easy money policy of 2002 and 2003 had been successful.

As 2005 went on, however, the Fed stopped accommodating the oil price increases, and in 2006, the Fed has even started pushing the other way. This is where the lag comes in. Because there really is a lag in the behavior of consumers, we won’t know until 2007 (or maybe even 2008) whether the oil price increases (which continued through 2005 and the first half of 2006) have reduced demand in the rest of the economy, as Ms. Baum would expect if the Fed were behaving itself. My guess is that, when all the votes are in, we will find that inflation has lost and that the Fed was right to ignore the direct effect of oil prices.

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4 Comments:

Blogger Gabriel M said...

Why do you mean by "we will find that inflation has lost and that the Fed was right to ignore the direct effect of oil prices"?

By "central bank was accommodating" do you mean to say that the Fed lowered rates and loosened the money supply to allow aggregate demand to expand to close the output gap opened by the shock, therefore permanently (for the time being, at least) rising inflation?

P.S. Thanks for the insightful comment on my site. I'm still chewing on it.

Mon Sep 18, 04:31:00 AM EDT  
Blogger knzn said...

To your first question, I mean that the inflation rate will decline again, which will justify the Fed’s tendency (particularly over the past year or so) to focus on the core inflation rate rather than the headline inflation rate. (Presumably, the Fed would have tightened more aggressively recently if they were focusing on headline inflation, and I suspect that would have ended up causing an unnecessarily severe recession and perhaps ultimately reviving earlier deflation fears.)

To the second question, in 2003 and 2004, I don’t think the Fed was reacting to the effects of the oil shock by easing. (They certainly didn’t cut interest rates after the oil shock became apparent.) There was an output gap before the oil shock hit, and, if the oil shock had not happened, the Fed might have continued its ultra-easy policy for even longer than it actually did. When I say “accommodating the oil price increases,” I just mean the Fed was continuing an accommodative policy in the face of oil price increases. The policy was premised on a larger output gap than what subsequently became apparent. The policy turned out to be inflationary, but the reason was not that the Fed was reacting to the oil shock by easing, but rather that the Fed’s forecast was wrong to begin with.

(At least that’s my story for now, but I’m not sure I’ll be sticking to it. I actually think we have continued to have an output gap all along, and I have to tell a more complicated story involving the interaction of lags and the fact that oil has repeatedly turned out to be scarcer than expected. Ultimately, I’ll fall back on the theoretical arguments in my previous post.)

Mon Sep 18, 09:57:00 AM EDT  
Anonymous Anonymous said...

knzn, Why don´t you comment on your guessing candidates as far as Nobel Prize in Economics (2006) is concerned? You holds a PhD in economics.
Thanks

Wed Sep 20, 04:55:00 PM EDT  
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