For release: Nov. 7, 2005

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St. Louis Fed Analysis Examines Uncertainty about Future Oil Prices and Their Effects on U.S. Economy

St. Louis, Mo. — While motorists anxiously watched the dollar dial on the gasoline pump ratchet higher and higher this year, monetary policymakers are equally concerned because most of the post-World War II recessions in the United States, including the 2001 recession, were preceded by sharp increases in crude oil prices.
Economists Hui Guo and Kevin L. Kliesen analyzed the overall effect of rising oil prices on the U.S. economy for the November/December issue of Review, the Federal Reserve Bank of St. Louis' bimonthly journal of economic and business issues.

"Oil shocks affect macroeconomic activity through various channels," said Guo and Kliesen. "For example, rising oil prices directly affect measures of inflation because they increase the price of gasoline and heating oil. Since this reduces the purchasing power of consumers, the growth of real personal consumption expenditures tends to slow. Higher oil prices also raise the cost to firms that are intensive users of petroleum-based products—airlines, trucking companies or package delivery firms, to name a few."

Many economists believe that oil price changes have "symmetric" effects. This is, if oil price increases are bad for the economy, then oil price decreases ought to be good. Guo and Kliesen also emphasized, however, that the effects can be asymmetric. "In particular," they said, "sharp oil price changes—either increases or decreases—may reduce aggregate output temporarily because it delays business investment by raising uncertainty or induces firms to switch between types of capital, or between labor and capital."

Guo and Kliesen noted such effects are costly, and in their analysis sought to determine whether one effect is more dominant.

Constructing a measure of energy price volatility from daily crude oil future prices traded on the New York Mercantile Exchange, they found that a measure of oil price volatility has a negative and significant effect on various key measures of the U.S. economy, including real GDP growth, fixed investment, consumption, employment and the unemployment rate from 1984 to 2004.

"Our results mean that an increase in the price of crude oil from, say, $40 to $50 per barrel generally matters less than increased uncertainty about the future direction of prices," said Guo and Kliesen.

In addition, Guo and Kliesen found that standard macroeconomic variables do not forecast oil price volatility. Their research suggests that changes in the supply and demand for crude oil that raise the variance of future crude oil prices tend to reflect random disturbances.

"This finding," they concluded, "implies that crude oil price volatility is mainly driven by random, external factors, such as large terrorist events or military conflicts in the Middle East."

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve Banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation’s central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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