Sunday, June 29, 2008

Worrying about inflation...It's not oil it's CHINA

If we look back at past episodes when inflation got out of control in the US in the past 25 years or so the culprit really was not oil. As hard as that is to believe it is true. Oil was contributing but it's hard to argue that it was casual.

Past oil shocks simply caught the US economy at inopportune times when inflation already was troublesome..

Oil shocks Compared
Shock Size Period Before Peak Change Before Peak Change
222.5% 73-75 5.7 12.2 6.5 3.2 11.9 8.7
164.2% 78-80 8.9 14.6 5.7 8.4 13.1 4.7
473.8% 03-08 2.4 4.1 1.7 1.3 2.3 1.0

The table above tells a version of that story. It shows CPI inflation and core inflation rates before the oil shocks and then at their peaks, after the 'shock'. What is clear is that in 1973 and in 1978 as oil prices went up sharply (by 222% and 164%, respectively) inflation already was elevated ahead of the shock itself. In 1973 it ran a 5.7% pace and in 1978 it already was knocking down nearly 9% per year before oil prices went up. Neither was core inflation well behaved at 3.2% in 1973 and 8.4% in 1978. On top of those starting marks, inflation rose sharply after the shock for both core and headline inflation- see the table.

In this episode that is not so. The oil price shock came with inflation at about 2.4% driving it up to 4.1% currently The post shock rate (that comes five or so years after the shock - a 'shock that has been more gradual in some ways) is still lower than it was BEFORE the previous shocks hit in earlier times. The same is true of core inflation.

Not only are the current inflation rates low compared to past pre-shock rates, but the amount by which prices have risen is much less. In the case of headline inflation in particular there may still more inflation in the pipeline so it's too early to count our 'chickens' as the saying goes. But there is NOTHING at all in these figures that is scary. The Fed is doing an excellent job - even worrying too much.

What is different is that in the aftermath of the second oil shock special factors brought oil demand and prices to heel. The second shock added to the previous one so there was more conservation in progress already. The high inflation meant that the Fed was tightening and a deep recession helped to cut oil demand and drop oil prices. Since prices had gone up sharply in 1973 there was also time for a supply response. Alaska oil (for one example) came on line.

As a result oil prices were routed.

In 2008 India's and China's rapid economic development will keep the pressure on as their demands continue to grow even if the US and world economies slow. Still, oil prices have been rising for some time. There is conservation afoot. There will be some supply responses. Alternative fuels at least are being explored. I think that the India and China cards are being being overplayed. History suggests that we can cope with these sorts of things much better than people fear. I would not discount either the conservation or supply responses to this shock especially given the height that prices have achieved. The prospects for a global recession to cool things off is not exactly remote even if it is not apt to be caused by spiking interest rates. High oil prices spread that same depressing effect. Beware.

1 comment:


China is closing the gap on the usa. Their GDP will match the us before the decade is over.