Rising Oil Prices: What Dangers Do They Pose for the Economy?

Publication Date: January 2001

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Energy

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Abstract:

The sharp rise in oil prices beginning in March 1999 reflects two factors: rising world oil demand and the Organization of Petroleum Exporting Countries' (OPEC's) successful restriction of supply. The most helpful way to consider the current situation may be to think of this year's price rise as partly a return to the average price range of the past caused by a revival in world demand and partly an increase above that range caused by OPEC's restriction of supply. The rise in world demand is mostly attributable to stronger economic growth, most notably the recovery in East Asia from the economic crisis of 1997 that drove oil prices to their lowest real price in thirty years. Restrictions in supply can be very effective at raising prices because it is so difficult to substitute away from oil consumption in the short run. But in the past OPEC has had little success in sustaining price increases in the long run. As more and more OPEC members exceed their production agreements, non-OPEC producers increase production, and consumers substitute away from oil, the price of oil has fallen.

What danger does the oil price rise pose for the US economy? Since both the high world demand and OPEC's restriction of supply have little to do with the American economy, they can be thought of as a textbook example of a "supply shock" to the American economy. The theoretical effects of this "supply shock" closely resemble events in past oil shocks: a simultaneous rise in inflation and a decrease in output in the short run, popularly known as stagflation. Since a policymaker can respond by tackling one problem only at the expense of the other, supply shocks pose a troublesome policy dilemma. If the Federal Reserve or Congress responds to the oil shock by employing expansionary monetary or fiscal policy, respectively, then they will counteract the decrease in output but aggravate inflation. Neutral policy would ease inflationary pressures eventually but prolong the economic downturn.

However, there is good reason to think that the effects on the US economy will be much milder in this case than they were in the past. First, once the portion of the price rise that is a return to the average range is omitted, the remaining price rise is not that large. Second, the US economy is less reliant on oil today than it was at the time of the first two oil shocks. Finally, there are structural differences in the oil market that may make OPEC's attempts to manipulate prices more difficult.

Economic growth was very strong in the United States through the first half of 2000. There are signs that economic growth may now be slowing, although it is still positive. At the same time, countering the purported slowdown with expansionary fiscal or monetary policy is difficult because the inflation rate has remained above 3.0%. While the oil price increase has had little negative effect in the aggregate economy prior to the third quarter of 2000, it is likely that it is contributing to both higher inflation and slower growth. It may be that domestic firms shrugged off the price increase at first, but eventually the pressure on profits and efficiency became too great to ignore. Some consider the recent turmoil in U.S. stock markets as evidence of this theory. This paper will be updated as events warrant.