Tuesday, 6 March 2012

Back to the Future

A tale of two Halfs

Between the mid-80s to 2007, we in the advanced economies have seen moderate output volatility [variance] and low inflation volatility. Many economists have in recent times including Ben Bernanke, the current Fed Chairman, attributed this to a combination and interaction of various factors: Good luck, lack of exogenous shocks, Monetary targeting and independence, East Asian Savings, low real world interest rates, financial innovations, and so on.

I would just like to briefly focus at the moment on one factor: the fluctuating levels of the oil price. Recently it was argued in a paper demand inelasticity for Oil varies after a certain threshold; additionally it also varies depending on whether it comes as a shock or not. Stable and cheap Oil prices for most of the 'Great Moderation' allowed for stable current and future investment and consumption, negating any volatility.

Oil is an important input into the real economy. With an oil shock, trade-off between Output Volatility and Inflation Volatility (Bernanke 2004) worsens. Policy response to this can be ambiguous. We are in some ways fortunate to have had an oil shock on the foot of the downturn; cost push inflation is easier to handle with lower GDP growth. However I use the term loosely, with rising demand, as many parts of the world integrate into the global economy and oil supply constrained at 90 million barrels per day, it is likely resumption to normal service of which we were used to will not be the case. With Brent crude currently trading around $120; the sight of £1.35/litre or $4/gallon at the pump could turn out to be a permanent shock.