Ben S Bernanke: Oil and the economy
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the Distinguished Lecture Series, Darton College, Albany, Georgia, 21 October 2004.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
If you have regular occasion to fill your car's tank with gas, you know that the price of gasoline has
recently been both high and volatile - a consequence, for the most part, of similar movements in the
price of crude oil.1 The weekly average price for a barrel of West Texas intermediate, a standard grade
of crude oil, hovered around $30 during the second half of 2003 but began to rise around the turn of
the year. The price per barrel reached $37 in March and nearly $41 in May. Oil prices have continued
to rise erratically since the spring, even as other commodity prices have generally stabilized and
overall inflation has been low. As of last week, the price of a barrel of West Texas intermediate stood
at about $55.2
Some perspective is in order. Oil prices are at record levels when measured in nominal terms, but
when adjusted for inflation the price of oil still remains well below its historical peak, reached in 1981.
Measured in today's dollars, crude oil prices in 1981 were about $80 per barrel, and the price of
gasoline at the pump was nearly $3 per gallon. Moreover, energy costs at that time were a larger
share both of consumers' budgets and of the cost of producing goods and services than they are
today. Clearly, the surges in oil prices of the 1970s and early 1980s had much more pronounced
economic effects than the more recent increases have had or are likely to have, barring a substantial
further rise.
All that being said, prices of oil and oil products in the United States today are quite high relative to
recent experience. During most of the 1990s, oil prices were roughly $20 per barrel, and for a short
period in 1998 (remembered without fondness by oil explorers and producers) the price of a barrel of
crude fell to just above $10. As I mentioned, only a year ago the price of oil was about $30 per barrel.
The recent rise in oil prices has thus been large enough to constitute a significant shock to the
economic system.
The runup in oil prices raises a number of important questions for economists and policymakers. Why
have oil prices risen by so much and why do they continue to fluctuate so erratically? What is the
outlook for oil supplies and oil prices in the medium term and in the long term? What implications does
the behavior of oil prices have for the ongoing economic expansion? And how should monetary policy
respond to these developments? I will touch briefly on each of these questions today. Before doing so,
I should note that the opinions I express today are my own and are not to be attributed to my
colleagues in the Federal Reserve System.3
Recent and prospective developments in oil markets
To assess recent developments in the oil market, it would be useful to know whether the high price of
oil we observe today is a temporary spike or is instead the beginning of an era of higher prices.
Although no one can know for sure how oil prices will evolve, financial markets are one useful place to
learn about informed opinion. Contracts for future deliveries of oil, as for many other commodities, are
traded continuously on an active market by people who have every incentive to monitor the energy
situation quite closely.4 Derivative financial instruments, such as options to buy or sell oil at some
future date, are also actively traded. The prices observed in these markets can be used to obtain
useful information about what traders expect for the future course of oil prices, as well as the degree of
uncertainty they feel in predicting the future.
One inference we can draw from recent developments in the oil market, in particular from the pricing of
derivative instruments, is that traders in that market are unusually uncertain about how the price of oil
will evolve over the next year or so. For example, as of last week, traders assigned about a two-thirds
probability that the price of crude oil as of next June would be between $38 and $60 per barrel. Or, to
say the same thing another way, traders perceived a one-third chance that the price of oil would fall
outside the wide $38-$60 range. That well-informed traders would be so uncertain about what the
price of oil will be only eight months in the future is striking, to say the least.
Uncertainty can in itself be a negative factor for the economy; for example, I would not rule out the
possibility that uncertainty about future energy costs has made companies a bit more cautious about
making new capital investments. However, probably more economically significant than near-term
uncertainty about oil prices is the fact that traders appear to expect tight conditions in the oil market to
continue for some years, with at best only a modest decline in prices. This belief on the part of traders
can be seen in the prices of oil futures contracts. Throughout most of the 1990s, market prices of oil
for delivery at dates up to six years in the future fluctuated around $20 per barrel, suggesting that
traders expected oil prices to remain at about that level well into the future. Today, futures markets
place the expected price of a barrel of oil in the long run closer to $39, a near doubling.5 Thus,
although traders expect the price of oil to decline somewhat from recent highs, they also believe that a
significant part of the recent increase in prices will be long lived.
What accounts for the behavior of the current and expected future price of oil? The writer George
Bernard Shaw once said that, to obtain an economist, it was only necessary to teach a parrot to repeat
endlessly the phrase "supply and demand." Well, as an economist, I have to agree with the parrot. For
the most part, high oil prices reflect high and growing demand for oil and limited (and uncertain)
supplies.
On the demand side, the International Energy Agency (IEA), perhaps the most reliable source of data
on world oil production and consumption, has continued to revise upward its projections of global oil
usage. To illustrate, world oil consumption for the second quarter of this year, the latest quarter for
which we have complete data, is now estimated to have been about 3.7 million barrels per day higher
than the IEA projected in July 2003.6 (For reference, total global oil consumption this year has
averaged about 81 million barrels per day). A significant part of this unexpected increase in oil
consumption, about 2.2 million barrels per day, reflected quickly growing oil demands in East Asia,
notably China. However, an ongoing economic expansion across both the industrialized and the
emerging-market economies has also contributed to the world's growing appetite for oil.
On the supply side, the production of oil has been constrained by the available capacity and by
geopolitical developments. With oil consumption and prices rising briskly, Saudi Arabia and other
members of the Organization of Petroleum Exporting Countries (OPEC) have promised to pump more
oil. However, the relatively limited increases in production delivered so far by OPEC members,
together with non-OPEC production that has fallen a bit below projections, have raised concerns that
the spare production capacity available in the near term may be severely limited, perhaps below
1 million barrels per day.
Interacting with the limits on capacity, and contributing to the exceptional volatility in oil prices of recent
months, are uncertainties about the reliability and security of oil supplies. Of course, the oil-rich Middle
East remains especially volatile. But political risks to the oil supply have emerged in nations outside
the Middle East as well, including Russia, Venezuela, and Nigeria. Weather also has taken a toll, as
recent hurricanes affected the production and distribution of oil on the U.S. Gulf Coast.
Because neither the demand for nor the supply of oil responds very much to price changes in the short
run, the recent unexpected rise in oil consumption together with disruptions to supply can plausibly
account for much of the increase in prices. However, the sharp increases and extreme volatility of oil
prices have led observers to suggest that some part of the rise in prices reflects a speculative
component arising from the activities of traders in the oil markets.
How might speculation raise the price of oil? Simplifying greatly, speculative traders who expect oil to
be in increasingly short supply and oil prices to rise in the future can back their hunches with their
money by purchasing oil futures contracts on the commodity exchange. Oil futures contracts represent
claims to oil to be delivered at a specified price and at a specified date and location in the future. If the
price of oil rises as the traders expect - more precisely, if the future oil price rises above the price
specified in the contract - they will be able to re-sell their claims to oil at a profit.
If many speculators share the view that oil shortages will worsen and prices will rise, then their
demand for oil futures will be high and, consequently, the price of oil for future delivery will rise. Higher
oil futures prices in turn affect the incentives faced by oil producers. Seeing the high price of oil for
future delivery, oil producers will hold oil back from today's market, adding it to inventory for
anticipated future sale. This reduction in the amount of oil available for current use will in turn cause
today's price of oil to rise, an increase that can be interpreted as the speculative premium in the oil
price.
Many people take a dim view of speculation in general, and in some instances this view is justified.7 In
many situations, however, informed speculation is good for society. In the case of oil, speculative
activity tends to ensure that a portion of the oil that is currently produced is put aside to guard against
the possibility of disruptions or shortages in the future. True, speculation may raise the current price of
oil, but that increase is useful in stimulating current production and reducing current demand, thereby
freeing up more oil to be held in reserve against emergencies. Speculative traders have no altruistic
motives, of course; their objective is only to buy low and sell high. But speculators' profits depend on
their ability to induce a shift in oil use from periods when prices are relatively low (that is, when oil is
relatively plentiful) to periods when prices are relatively high (when oil is scarce). Social welfare is
likely increased by informed speculation in oil markets because speculative activities make oil
relatively more available at the times when it is most needed.8
This discussion suggests three indicators to help us detect the influence of speculative activity on
current oil prices. First, if speculative activity is an important source of the rise in oil prices, we would
expect today's oil price to react strongly to news bearing on future conditions of oil supply and
demand. Second, we should see speculative traders holding claims to large amounts of oil for future
delivery, in the hope of enjoying a profit by re-selling the oil should prices rise. Finally, corresponding
to the speculative positions held by traders, we would expect to see significant increases in the
physical inventories of oil being held for future use.
The first indicator, rapid swings of oil prices in response to news about the prospective supplies and
usage of oil, does appear to be present and to suggest a speculative element in pricing. It is thus
somewhat puzzling that the other two indicators of speculative activity do not appear to be present:
Our best-available measure of speculative traders' holdings of contracts for future delivery of crude oil
and petroleum products has decreased from earlier in the year and is not unusually high by historical
standards.9 And official data imply that physical inventories of crude oil and petroleum products, at
least within the industrial countries for which we have good data, have not risen to any significant
degree and at times have even been below seasonal norms.10 Perhaps the official data overlook
important accumulations of crude oil stocks - in China and other emerging-market economies, for
example - but that remains (if you will excuse the expression) speculation. My tentative conclusion is
that speculative activity may help to account for part of the recent volatility in oil prices. However, the
available evidence does not provide clear support for the view that speculative activity has made oil
prices during the past year much higher on average than they otherwise would have been.11
A rather different explanation of the recent increase in oil prices holds that the rise is in large part a
symptom of inflationary monetary policies. An extensive literature exists on this topic. The general idea
is that, if most prices adjust slowly, the effects of an excessively easy monetary policy will show up first
as a sharp increase in those prices that are able to adjust most quickly, such as the prices of
commodities (including oil). If this idea were valid, then commodity price movements could be used as
a guide for setting monetary policy.
However, the consensus that emerges from this literature is that the relationship between commodity
price movements and monetary policy is tenuous and unreliable at best. Moreover, applied to the
recent experience, economic models that support the use of oil prices as a leading indicator of
monetary policy make a number of other predictions that are strongly contradicted by the facts. These
predictions include (1) that all commodity prices should move proportionally in response to changes in
monetary policy (in fact, oil prices have risen sharply since the spring as other commodity prices have
generally stabilized); (2) that the dollar should have rapidly depreciated as the oil price rose (in fact,
the dollar has been broadly stable during 2004); (3) that inflation expectations should have increased
substantially (but long-term nominal interest rates, the level of inflation compensation implicit in
inflation-indexed bond yields, and survey measures of inflation expectations concur in showing no
such rise); and (4) that general inflation, though lagging commodity-price inflation, should also rise
over time (but inflation excluding energy prices remains quite low). Models of commodity-price
"overshooting" also imply that the current surge in oil prices will be almost entirely temporary, a
prediction strongly at variance with market expectations as revealed in the futures markets. I conclude
that an increasingly tight supply-demand balance, rather than speculation or easy monetary policies,
probably accounts for most of the recent run-up in oil prices.
I have focused on near-term developments in the oil markets. What about the longer term? In that
regard, we can safely assume that world economic growth, together with the rapid pace of
industrialization in China, India, and other emerging-market economies, will generate increasing
demands for oil and other forms of energy. If we are lucky, growth in the demand for energy will be
moderated by continued improvements in energy efficiency that will be stimulated by higher prices and
concerns about the security of oil supplies. Such improvements are certainly possible, even without
new technological breakthroughs. For example, Japan is an advanced industrial nation that uses only
about one-third as much energy to produce each dollar of real output as the United States does.12
Industrializing nations such as China appear to be quite inefficient in their energy use; for example, the
underdeveloped electricity grid in China has induced heavy use of inefficient diesel-powered
generators. As these countries modernize, their energy efficiency will presumably improve. Still, if the
global economic expansion continues, substantial growth in the use of oil and other energy sources
appears to be inevitable.
10
Oil market data for the United States, including inventories data, are released weekly by the Energy Information
Administration, part of the U.S. Department of Energy. Each month, the International Energy Agency releases analogous
information covering the thirty member countries of the Organization for Economic Development and Cooperation (OECD).
11
Weiner (2002) surveys the academic literature and concludes that, over the long term, speculative activity has not much
affected the average price of oil. The apparently strong effect on oil prices of recent hurricanes in the Gulf of Mexico, which
led to short-term reductions in production, is a bit of evidence that high prices reflect a tight supply-demand balance rather
than speculative hoarding. If inventories or spare production capacity had been available, the shortfalls created by
hurricanes could have been replaced, and the price effect would have been more muted.
A somewhat different question is whether future prices for oil contain a significant risk premium. The finding of Chinn,
LeBlanc, and Coibion (2001) that futures prices are unbiased predictors of future spot prices argues against a large risk
premium. Estimates by the Board's staff, based on the methods of Pindyck (2001), indicate that the risk premium in oil
futures was no more than $2 or so even during the recent spikes in prices.
12
Japan may set an unreasonably high standard: That country's small area reduces the use of energy for transportation, and
the low average size of homes on these densely populated islands reduces heating and cooling costs. Japan also produces
a different mix of goods and services than the United States, a mix that may be less energy-intensive. On the other hand,
not even Japan has made full use of the energy conservation potential of existing technologies, such as hybrid autos for
example.
BIS Review 60/2004
The supply side of the oil market is even more difficult to predict. In a physical sense, the world is not
in imminent danger of running out of oil. At the end of 2003, the world's proved reserves of oil - that is,
oil in the ground that is viewed as recoverable using existing technologies and under current economic
conditions - reached more than 1.15 trillion barrels, 12 percent more than the world's proved reserves
a decade earlier and equal to about forty years of global consumption at current rates (BP Statistical
Review of World Energy, 2004, p. 4). Of course, global oil consumption will not remain at current rates;
it will grow. But, on the other hand, today's proved reserve figures ignore not only the potential for new
discoveries but also the likelihood that improved technology and higher oil prices will increase the
amount of oil that can be economically recovered.
The oil is there, but whether substantial new production sources can be made available over the next
five years or so is in some doubt. Some important fields are in locations that are technically difficult
and time-consuming to develop, such as deep-water fields off West Africa, in the Gulf of Mexico, or off
the east coast of South America. In many cases, the development of new fields also faces the
challenge of recovering the oil without damaging delicate ecosystems, if indeed the political process
allows exploitation of ecologically sensitive fields at all. I have already noted the uncertainties
generated by geopolitical instability; perhaps it is sufficient here to note that, despite the opening of
fields in a number of new regions in the past decade, about 63 percent of known oil reserves today are
in the Middle East. Oil producers are also aware from painful experience that oil prices can fall as
quickly as they rise; hence, exploration projects launched when prices are high may come to fruition
when prices are much lower. These risks help to explain why major oil companies have not rushed to
increase exploration activities during this recent period of high prices.
Thus, the supply-demand fundamentals seem consistent with the view now taken by oil-market
participants that the days of persistently cheap oil are over. The good news is that, in the longer run,
we have options. I have already noted the scope for improvements in energy efficiency and increased
conservation. Considerable potential exists as well for substituting other energy sources for oil,
including natural gas, coal, nuclear energy, and renewable sources such as wind and hydroelectric
power. For example, the world has vast supplies of natural gas that, pending additional infrastructure
development, might be transported in liquefied form to the United States, Europe, Asia, and elsewhere
at BTU-equivalent prices below those expected for crude oil. Given enough time, market mechanisms
(most obviously, higher prices) are likely to increase energy supplies, including alternative energy
sources, while simultaneously encouraging conservation and substitution away from oil to other types
of energy. These adjustments will not occur rapidly, however. Hence the next few years may be
stressful ones for energy consumers, as stretched and uncertain supplies of oil and other conventional
energy sources face the growing demands of a rapidly expanding world economy.
Economic and policy implications of increased oil prices
What are the economic implications of the recent increase in oil prices? In the long run, higher oil
prices are likely to reduce somewhat the productive capacity of the U.S. economy. That outcome
would occur, for example, if high energy costs make businesses less willing to invest in new capital or
causes some existing capital to become economically obsolescent. Lower productivity in turn implies
that wages and profits will be lower than they otherwise would have been. Also, the higher cost of
imported oil is likely to adversely affect our terms of trade; that is, Americans will have to sell more
goods and services abroad to pay for a given quantity of oil and other imports. The increase in the
prices of our imports relative to the prices of our exports will impose a further burden on
U.S. households and firms.
Under the assumption that oil prices do not spike sharply higher from their already high levels, these
long-run effects, though negative, should be manageable. As I have already discussed, conservation
and the development of alternative energy sources will, over the long term, take some of the sting out
of higher oil prices. Moreover, productivity gains from diverse sources, including technological
improvements and a more highly educated workforce, are likely to exceed by a significant margin the
productivity losses created by high oil prices.
In the short run, sharply higher oil prices create a rather different and, in some ways, a more difficult
set of economic challenges. Indeed, a significant increase in oil prices can simultaneously slow
economic growth while stoking inflation, posing hard choices for monetary policy makers.
An increase in oil prices slows economic growth in the short run primarily through its effects on
spending, or aggregate demand. Because the United States imports most of its oil, an increase in oil
prices is, as many economists have noted, broadly analogous to the imposition of a tax on
U.S. residents, with the revenue from the tax going to oil producers abroad. Since the beginning of the
year, the cost of oil imported into the United States has increased by about $75 billion (at an annual
rate), or about 3/4 percent of the gross domestic product (GDP). Add to this the effects of the rise in
natural gas prices, and the total increase in imported energy costs over a full year - the increase in the
"tax" being paid to foreign energy producers - comes to almost $85 billion.
The impact of this decline in net income on the U.S. GDP depends in large part on how the increase in
the energy "tax" affects the spending of households and firms. For a number of reasons, an increase
of $85 billion in payments to foreign energy producers is likely to reduce domestic spending by
something less than that amount. For example, in the short run, people may be reluctant to cut
non-energy spending below accustomed levels, leading them to reduce saving rather than spending.
Because high energy costs lower firms' profits, they normally reduce the willingness of firms to
purchase new capital goods; however, if the increase in energy prices looks to be permanent, firms
might decide that it makes sense for them to invest in more energy-efficient buildings and machines,
moderating the decline in their capital spending. If higher energy prices reflect in part more rapid
economic growth abroad - which seems to be the case in the recent episode - or if foreign energy
producers spend part of their increased income on U.S. goods and services, then the demand for
U.S. exports may be stronger than it would have been otherwise. With these and many other
qualifications taken into account, a reasonable estimate is that the increased cost of imported energy
has reduced the growth in U.S. aggregate spending and real output this year by something between
half and three-quarters of a percentage point.
At the same time that higher oil prices slow economic growth, they also create inflationary pressures.
Higher prices for crude are passed through, with only a very short lag, to increased prices for oil
products used by consumers, such as gasoline and heating oil. When oil prices rise, people may try to
substitute other forms of energy, such as natural gas, leading to price increases in those alternatives
as well. The rise in energy costs faced by households represents, of course, an increase in the cost of
living, or inflation. This direct effect of higher energy prices on the cost of living is sometimes called the
first-round effect
on inflation. In addition, higher energy costs may have indirect effects on the inflation
rate - if, for example, firms pass on their increased costs of production in the form of higher consumer
prices for non-energy goods or services, or if workers respond to the increase in the cost of living by
demanding higher wages. These indirect effects of higher energy prices on the overall rate of inflation
second-round
are called effects. The overall inflation rate reflects both first-round and second-round
effects, of course. Economists and policymakers also pay attention to the so-called core inflation rate,
which excludes the direct effects of increases in the prices of energy (as well as of food). By stripping
out the first-round inflation effects, core inflation provides a useful indicator of the second-round effects
of increases in the price of energy.13
In the past, notably during the 1970s and early 1980s, both the first-round and second-round effects of
oil-price increases on inflation tended to be large, as firms freely passed rising energy costs on to
consumers, and workers reacted to the surging cost of living by ratcheting up their wage demands.
This situation made monetary policy making extremely difficult, because oil-price increases threatened
to raise the overall inflation rate significantly. The Federal Reserve attempted to contain the
inflationary effects of the oil-price shocks by engineering sharp increases in interest rates, actions
which had the unfortunate side effect of sharply slowing growth and raising unemployment, as in the
recessions that began in 1973 and 1981.
Since about 1980, the Federal Reserve and most other central banks have worked hard to bring
inflation down, and in recent years, inflation in the United States and other industrial countries has
been both low and stable. An important benefit of these efforts is that the second-round inflation effect
of a given increase in energy prices has been much reduced (Hooker, 1999). Because households
and business owners are now confident that the Fed will keep inflation low, firms have both less
incentive and less ability to pass on increased energy costs in the form of higher prices, and likewise
workers have less need and less capacity to demand compensating increases in wages. Thus,
increases in energy prices, though they temporarily raise overall inflation, tend to have modest and
transient effects on core inflation; that is, currently, the second-round effects appear to be relatively
small.
Although the difficulties posed by increases in oil prices are less than in the past, the economic
consequences are nevertheless unpleasant, as higher oil prices still tend to induce both slower growth
and higher inflation. How then should monetary policy react? Unfortunately, monetary policy cannot
offset the recessionary and inflationary effects of increased oil prices at the same time. If the central
bank lowers interest rates in an effort to stimulate growth, it risks adding to inflationary pressure; but if
it raises rates enough to choke off the inflationary effect of the increase in oil prices, it may exacerbate
the slowdown in economic growth. In conformance with the Fed's dual mandate to promote both high
employment and price stability, Federal Reserve policy makers would ideally respond in some
measure to both the recessionary and inflationary effects of increased oil prices. Because these two
factors tend to pull policy in opposite directions, however, whether monetary policy eases or tightens
following an increase in energy prices ultimately depends on how policymakers balance the risks they
perceive to their employment and price-stability objectives.
An important qualification must be added, however. The relatively small effects of higher oil prices on
the underlying inflation rate that we have seen in recent years are a consequence of the public's
confidence that the Fed will maintain inflation at a low level in the medium term. As I have discussed,
the public's expectation that inflation will remain low minimizes the second-round effects of oil price
increases, which (in a virtuous circle) helps to limit the ultimate effect on inflation. Moreover,
wellanchored inflation expectations have been shown to enhance the stability of output and employment.
Maintaining the public's confidence in its policies should thus be among the central bank's highest
priorities.14 For this reason, I would argue that the Fed's response to the inflationary effects of an
increase in oil prices should depend to some extent on the economy's starting point. If inflation has
recently been on the low side of the desirable range, and the available evidence suggests that inflation
expectations are likewise low and firmly anchored, then less urgency is required in responding to the
inflation threat posed by higher oil prices. In this case, monetary policy need not tighten and could
conceivably ease in the wake of an oil-price shock. However, if inflation has been near the high end of
the acceptable range, and policymakers perceive a significant risk that inflation and inflation
expectations may rise further, then stronger action, in the form of a tighter monetary policy, may well
prove necessary. In directing its policy toward stabilizing the public's inflation expectations, the Fed
would be making an important investment in future economic stability.
I will close by briefly linking this discussion to recent Federal Reserve policy. As a professor and
textbook author, I was accustomed to discussing the effects of a particular phenomenon, such as
rising oil prices, with all other factors held equal. However, as policymakers know, everything else is
never held equal. The increases in oil prices this year did not take place in isolation. Along with the
rise in oil prices, increases in the prices of other important commodities, such as steel and lumber, as
well as higher import prices resulting from the earlier decline in the dollar, provided supply-side
pressure on inflation in early 2004. Meanwhile, an economic expansion that took hold in the middle of
2003 resulted in strong output growth but, as of early this year, limited progress in creating new jobs.
As a final complication, the beginning of the year also saw the Fed's policy interest rate, the federal
funds rate, at the historically low level of 1 percent, the result of the efforts of the Federal Open Market
Committee (FOMC) to spark faster growth and minimize deflation risks in 2003. In January, with
inflation low and the job market still weak, the FOMC indicated that it would be "patient" in removing
the policy accommodation implied by the low value of the federal funds rate.
The increase in inflation that occurred last sprin