Matt asks: Do High Oil Prices Doom The US Economy?

And tentatively gives an answer:

But it looks to me as if a demand-side oil issue is really just the same old issue of the trade deficit and the international balance of payments and not the second coming of a 1970s-style oil price shock. Perhaps it’s a monetary policy issue. We send dollars abroad in exchange for oil, but then the dollars get sent back in exchange for bonds. That ought to lower interest rates and induce investment in the United States, but nominal interest rates are already at zero so the loop is cut. Even so, higher gas prices should push the price level up which pushes real interest rates down which induces investment in the United States. The chain will only be broken here if the Fed decides to ignore its own self-guidance and target headline inflation instead of core inflation. If you do what the ECB does and react to an increase in the price of oil imports with tighter money, then clearly higher oil prices slow growth. But that’s the ECB blundering (a specialty in Frankfurt) not oil prices strangling growth per se.

Matt, you are on the right track. This is the conclusion of a paper by Bernanke and Gertler (Systematic Monetary Policy and Oil Price Shocks) written in 1997:

Substantively, our results suggest that an important part of the effect of the oil price shocks on the economy results NOT from the change in oil prices per se, but from the resulting tightening of monetary policy. This finding may help explain the apparently large effects of oil price changes found by Hamilton (1983) and many others.

The paper is obviously technical, so only the cognoscenti will be able to read it through. But no matter, there´s a very simple way to show why the conclusion makes sense, and also why Market Monetarists think it´s preferable to target nominal spending (NGDP), level target, instead of inflation (BTW, Matt is right in thinking that targeting Headline inflation is worse than targeting Core inflation).

There´s no doubt, just imagining a dynamic AS-AD model that an oil price shock increases inflation and reduces real output, but the strength of the oil price effect on real output is predicated on how the Fed reacts to the shock.

If the Fed reacts to the rise in inflation by contracting nominal spending (NGDP), real output is going to decrease more than if the Fed kept nominal spending “constant”. This is clearly seen in the following graph, representing a dynamic AS-AD model, where point 1 is the initial state and points 2 and 3 represent, respectively, the states following the oil price shock and the oil shock cum contraction in AD:

So it´s very frustrating, to say the least, to see that in 2008, when the economy was already nominally weakened from the fall in house prices and its effects on the financial sector, that Bernanke should have reacted to Headline inflation, which reflected the rise in oil and commodity prices, giving way to the largest nominal spending contraction since 1938. That´s the proverbial “throwing lots of salt in an open wound”. The pain just “shoots up”!