Remarks by Governor Edward M. Gramlich At the Annual Economic Luncheon, Federal Reserve Bank of Kansas City, Kansas City, Missouri
September 16, 2004
Oil Shocks and Monetary Policy
federalreserve.gov
A final issue involves the initial position of the economy and monetary policy. In the usual exercise,
one analyzes the economy in some sort of equilibrium position and posits an oil price shock, which
normally results in the temporary increases in inflation and unemployment described earlier. When
monetary policy begins with inordinately low nominal interest rates, the reasoning becomes more
complicated. Now the response to the oil shock is, in effect, superimposed on any re-equilibration
process built in for monetary policy. The ultimate response of the economy will blend the two
responses, though not additively because of the complicated nonlinear structure of the economy.
The net effect of these factors is difficult to perceive in any more than broad outline. Without the oil
shock, policymakers beginning from a period of low interest rates would try to keep the economy on
an even growth path as they gradually raised nominal interest rates. With the shocks, nominal rates
would still likely follow an upward path, though the economic reactions would be bumpier, with
temporary rises in both inflation and unemployment.
* * *
As a new economic event of the 1970s, oil price shocks forced monetary policy makers to rethink all
their rules and added new chapters to macroeconomic textbooks. Today the question of how to
respond to oil price spikes is better understood, but the outcomes are no more pleasant. It is virtually
inevitable that shocks will result in some combination of higher inflation and higher unemployment for a
time. But I must stress that the worst possible outcome is not these temporary increases in inflation
and unemployment. The worst possible outcome is for monetary policy makers to let inflation come
loose from its moorings. |
