Higher Oil Prices Could Lead to Higher Overall and Core Inflation Rates: St. Louis Fed Analysis

ST. LOUIS — Although the price of petroleum has moderated recently, a permanent increase to $150 per barrel by the end of 2008 could have a significant negative effect on the rate of real gross domestic product (GDP), at least in the short run, based on an analysis from the Federal Reserve Bank of St. Louis.

Kevin L. Kliesen, an economist with the St. Louis Fed, analyzed the price of oil and the U.S. macroeconomy for the September/October issue of Review, the Reserve Bank's bi-monthly journal of economic and business issues. The publication is also available online at the St. Louis Fed's web site: https://research.stlouisfed.org/publications/review.

Nearly all post-World War II recessions in the United States were preceded or accompanied by an increase in oil prices, which is why oil price shocks are viewed with alarm by forecasters, macroeconomists, financial market players and public policymakers. "An oil price shock," Kliesen explained, "is typically a large, unexpected increase in the relative price of energy that affects the economic decisions of firms and households."

An oil price increase may lower real GDP through several channels. For one, higher prices raise uncertainty about future oil prices and, thus, can cause delays in business investment. Second, dramatic oil price changes induce "resource reallocation," such as the major automakers switching production from trucks and SUVs to smaller cars and hybrids.

Kliesen said that estimates of the short-run macroeconomic effects of higher oil prices on real GDP growth can vary. Employing a simple forecasting exercise based on an augmented version of a well-known economic model that explains changes in real GDP growth based on changes in oil prices, he found that an additional $50-per-barrel increase in the price of crude oil would cut real GDP growth by about 0.25 percentage points in 2008, although by only 0.1 percentage points in 2009. "Statistically, real consumption expenditures would experience similarly large but more persistent negative growth," said Kliesen.

The model predicts that a permanent increase in crude oil prices to $150 per barrel would cause overall and core personal consumption expenditures price index (PCEPI) inflation to rise to 4 percent in 2009.

"If correct," Kliesen concluded, "these results suggest that policymakers may need to be more vigilant if oil prices rise to limits that were thought to be unlikely by most analysts."

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, provides payment services to financial institutions and the U.S. government, and promotes community development and financial education.

# # #