Links to debate on full employment/inflation

Matt McOsker,
“would argue that 70′s inflation was caused by oil prices, and it ended because oil prices stabilized, and the fed sent rates up high enough to kill the economy and demand further hurting il prices.”

Total energy expenditures as a percent of GDP rose from 8.0% in 1970 to 13.7% in 1980, a change of 5.7 points.

http://www.eia.gov/totalenergy/data/annual/pdf/sec1_13.pdf

The EIA doesn’t have total energy expenditure data from before 1970 but the price of crude petroleum in 2005 dollars was $4.46 per barrel according to the World Bank dataset and this was less than in any year in 1960-69 and was down 26.6% from its price of $6.08 a barrel in 1965:

http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTDECPROSPECTS/0,,contentMDK:21574907~menuPK:7859231~pagePK:64165401~piPK:64165026~theSitePK:476883,00.html

So chances are very good that total energy expenditures in 1970 as a percent of GDP had fallen from the level they had been in 1965 and yet core inflation had had already risen from 1.3% in 1965 to 4.7% in 1970, and continued to accelerate reaching 9.2% in 1980:

http://research.stlouisfed.org/fred2/graph/?graph_id=109579&category_id=0

In contrast total energy expenditures as a percent of GDP rose from 5.9% in 1999 to 9.9% in 2008, an increase of 4.0 points, and yet core inflation only rose from 1.3% to 2.3%.

So in the Great Inflation a change in total energy expenditures of less than 5.7 points resulted in an increase in core inflation of 7.9 points and in the 2000s a change in total energy expenditures of 4.0 points resulted in an increase in core inflation of 1.0 points.

This shouldn’t be surprising because research shows that commodity price increases are not an important causal factor in long-term inflation:

http://www.bostonfed.org/economic/ppb/2011/ppb111.pdf

Do Commodity Price Spikes Cause Long-Term Inflation?
Geoffrey M. B. Tootell
May 2011

Abstract:
“This public policy brief examines the relationship between trend inflation and commodity price increases and finds that evidence from recent decades supports the notion that commodity price changes do not affect the long-run inflation rate. Evidence from earlier decades suggests that effects on inflation expectations and wages played a key role in whether commodity price movements altered trend inflation. This brief is based on a memo to the president of the Federal Reserve Bank of Boston as background to a meeting of the Federal Open Market Committee.”

P.S. The real long-run neutral rate of interest for the US is about 2%. Whenever the fed funds rate is below that rate monetary policy is probably expansionary (“probably” because the real short-run neutral rate of interest may be different). The following graph shows the fed funds rate adjusted by core PCEPI inflation (i.e. the real fed funds rate)*minus two* in red and the residuals from a Taylor Rule in blue:

http://research.stlouisfed.org/fred2/graph/?graph_id=127023&category_id=0

You can see that the real fed funds rate was below the real long-run neutral rate for most of the 1970s. And since the unemployment rate was below the natural rate of unemployment (NROU) for most of 1963 through 1974 it’s not surprising that interest rates were unusually low by a Taylor Rule for most of the 1960s and 1970s as well.

Matt McOsker,
“Mark oil prices went from $4.46 a barrel to over $35. That is a huge increase. Oil was about 4% of GDP in 1970 to over 8% in 1980.”

Your comment has forced me to take a closer look at this World Bank commodity price data and although they say the real prices are in 2005 dollars they can’t be because that would imply the price level only rose by 32% from 1981 through 2005. So I’m going assume the nominal prices are okay and convert them to real using the GDP implicit price deflator:

http://research.stlouisfed.org/fred2/series/A191RD3A086NBEA

This won’t change what I said before much but it will make it easier to present some new facts to clarify the specific issue of oil prices.

Real world crude oil prices fell from $7.59 a barrel in 1965 to $5.31 a barrel in 1970, or by 30.0%, and then rose to $82.99 a barrel in 1980, or an increase by a factor of 15.62. For comparison real world crude oil prices rose from $16.54 a barrel in 1998 to $97.74 a barrel in 2008, or an increase by a factor of 5.90. So far this supports what you are saying.

However let’s look at expenditures on petroleum. Expenditures by energy source can be found here:

http://www.eia.gov/totalenergy/data/annual/pdf/sec3_11.pdf

Combine that with the GDP figures from the other EIA document I linked to above and what you’ll find is the following.Expenditures on petroleum rose from 4.6% of GDP in 1970 to 8.5% of GDP in both 1980 and 1981, or an increase of 3.9 points. For comparison expenditures on petroleum rose from 2.6% of GDP in 1998 to 6.1% of GDP in 2008, or an increase of 3.5 points.

Recall that core inflation rose from 1.3% in 1965 to 4.7% in 1970 to 9.2% in 1980. But core inflation only rose from 1.2% in 1998 to 2.3% in 2008. So the increases in the proportions of GDP spent on oil are virtually identical and yet core inflation did not soar in the 2000s. Thus the idea that oil prices caused the Great Inflation makes little sense to me.

Now, this raises a legitimate question, how is it that real world crude oil prices can go up nearly 16 fold in one case and the amount spent on petroleum *less* than doubles in the 1970s, and the real world crude oil price goes up nearly 6 fold in the 2000s and the amount spent on petroleum *more* than doubles?

One issue is that US crude oil prices did not rise anywhere near that much in the 1970s. The real US price of oil was $14.35 a barrel in 1965, $13.52 in 1970 and $77.39 in 1980, so US crude oil prices only rose by 5.72 fold in the 1970s:

http://research.stlouisfed.org/fred2/graph/?graph_id=136738&category_id=0

Until 1979 US crude oil prices were significantly higher than world crude oil prices, and as of 1965 and 1970 imported oil represented only 19.8% and 20.7% of total oil consumption respectively:

http://www.eia.gov/totalenergy/data/annual/pdf/sec5_6.pdf

Furthermore the price of crude oil relative to the consumption price was a lot lower in 1970 than it was later.

If you take the average daily consumption figures from the link just above and multiply them by 365 you can convert them to annual averages. Then take the annual expenditures and divide them by the consumption amounts you’ll get the average consumption price of petroleum products. Then finally convert them to real prices using the GDP implicit price deflator and this is what you will find.

The real consumption price of a barrel of oil rose from $35.98 in 1970 to $85.64 in 1980 or by 138.0%. For comparison the real consumption price of a barrel of oil rose from $33.56 in 1998 to $122.34 in 2008 or by 264.5%. Thus the impact of the oil price increases on the actual price of a barrel of oil to the consumer was actually far worse in the 2000s than in the 1970s.

It’s interesting to note that US crude oil prices were 37.6% of the consumption price of a barrel of oil in 1970, 90.4% in 1980, 49.9% in 1998 and 75.4% in 2008. Furthermore world crude oil prices were only 14.8% of the consumption price of a barrel of oil in 1970. A weighted averaged of domestic and world crude oil prices suggests that in 1970 crude oil prices were only about one third of the consumption price of a barrel of oil in 1970.

Matt McOsker,
“Mark it begs the question then, what prices went up to cause the “great” inflation. Something had to go up in price.”

Prices going up are the *effect*, not the *cause* of inflation.

Oil prices rose more than general prices. That is a relative price change. But there is no evidence that relative price changes cause general price inflation.

“If oil is the contributor, then that price is not controlled for the most part by the Fed. Similarly, other countries experienced similar inflation. Again those countries were not controlled by the fed either.”

Well, I hope we’ve eliminated oil as a suspect.

Many advanced nations experienced high inflation in the 1970s. but they didn’t all experience it to the same degree or have inflation peak at the same time. For example, among OECD members, core CPI inflation peaked in Japan in 1974 at 20.2%. Core CPI inflation also peaked in Germany that year at only 6.8%:

http://research.stlouisfed.org/fred2/graph/?graph_id=136803&category_id=0

By the time US core CPI inflation peaked at 12.4% in 1980, core inflation had fallen to only 5.7% and 5.3% in Japan and Germany respectively. Turkey’s CPI inflation rate didn’t peak until 1994 at 105.2% by which time core CPI was only 0.9% in Japan, and 2.8% in Germany and the US. Last year CPI inflation was only 8.9% in Turkey.

And this doesn’t even consider the even greater diversity of inflation histories among the developing countries.

“And quite frankly I don’t feel that inflation overall was that out of control in the seventies overall.”

I don’t think it impaired the functioning of the economy as much as many would have us believe. But I also think central banks would be much better off practicing nominal GDP level targeting (NGDPLT) than Inflation Targeting (IT).