Another Yale professor, William D. Nordhaus, contributed a paper to last weeks BPEA celebration at the Brookings Institution. When the U.S. invaded Iraq in March 2003, many economists feared that the war would lead to a sharp decline in Iraqi oil production, a spike in oil prices, and a woeful economy that would follow the scripts of the oil shocks of 1973, 1978, and 1990. What happened and why is analysed by Nordhaus in a paper entitled: Who’s Afraid of a Big Bad Oil Shock? (PDF). Here are his conclusions:
So what should we conclude? To begin with, the oil shock of 2002-2006 was different from those of earlier period. If we measure the shock as the income effect per year of the price increases, the shock was substantially smaller than the shocks of the 1970s. It occurred more gradually, and the change was much less of a surprise in the context of past experience. Roughly speaking, the shock was about one-third as large as the shocks of the 1970s.
In terms of effects, the impact of the shock on inflation was qualitatively similar although quantitatively different from the earlier shocks. The rise in PCE inflation in the recent shock was consistent with less than full pass-through of the energy-price increase. Unlike the shocks of the 1970s, there appears to have been no substantial pass-through of the energy-price increases into wages or other prices.
The impact of the shock on output was completely different from earlier episodes – indeed the sign was opposite. Output continued to grow relative to potential output after the shock, and unemployment continued to fall. The reason for the anomalous output impact is unclear. One possible reason is that the shock was too small to affect the overall pace of economic growth.
Additionally, there is modest evidence that the transmission mechanism from energy prices to output has changed from negative to neutral over the last three decades. The reasons for the declining sensitivity are not completely understood, but two underlying causes seem plausible. First, there is evidence that the Federal Reserve reacted more sensibly to energy prices in the 2000s.. ...A second and more speculative reason for the muted macroeconomic reaction is that consumers, businesses, and workers may see oil-price increases as volatile and temporary movements rather than the earth-shaking changes of the 1970s. ...All of these factors would tend to reduce the impact of energy-price shocks on the macroeconomy.
In the end, this suggests that much of what we should fear from oil-price shocks is the fearful overreactions of the monetary authority, consumers, businesses, and workers. A cautious reading today suggests that policymakers should not be afraid of a Big Bad Oil Shock. The most recent evidence suggests that the economy is robust in the face of major energy shocks. The economy weathered an increase in real oil prices of 125 percent from 2002 to 2006 without any major strain. This suggests that policymakers should focus on fundamentals such as employment, real output, and containment of inflation as well as the instabilities caused by financial innovations and risk-taking. Oil-price shocks are neither so big nor as bad as in the 1970s.
See also the background documentation: Notes on Data and Methods (PDF)