Will oil prices cause a double dip?

Just when the good economic news of the last few months was beginning to sink in, the nation’s newspapers are full of headlines about rising gas prices. Gasoline prices are already up 8 percent this year. Oil rose to $103.24 a barrel Monday on news of increased tensions in Iran, up from a low of $76.29 last October. And many expect prices will continue to rise as we head into the summer months.

There are obvious downsides to higher gas prices. Rising fuel costs hurt businesses that rely on transport (which is most of them). And the more money people pour into their gas tanks, the less they have to spend on other things. But perhaps the biggest threat posed by higher fuel prices is the effect they may have on the Federal Reserve.

Under its “dual mandate,” the Federal Reserve is supposed to avoid both high inflation and high unemployment. If the Fed thinks unemployment is too high, it can attempt to jump start the economy by “easing” monetary policy, i.e. by printing more currency and then putting that currency into circulation. Since dollars represent demand for goods and services, the extra currency in circulation will lead to a greater demand for goods and services. As with any increase in demand, businesses can respond either by increasing their supply or by raising prices. To the extent they do the former, unemployment will tend to fall as businesses hire more workers to expand their operations. To the extent they do the latter, inflation will tend to rise. By contrast, if the Fed is worried about high inflation, it can “tighten” monetary policy by selling bonds, which will suck money out of the economy and have the opposite effects.

However, when oil prices spike for some non-monetary reason (unrest in the Middle East, say, or increased demand from China), the danger of inflation might seem greater than it actually is. This could lead the Fed to tighten prematurely, which could kill an incipient economy recovery. To minimize this danger, the government maintains an index of “core” inflation (excluding volatile items like food and fuel) in addition to the more comprehensive headline inflation data. In practice, however, the political pressures that come from rising gas prices can be hard to ignore.

As Bentley economics professor Scott Sumner (who writes the influential Money Illusion blog) has noted, “oil shocks explain many of our monetary policy failures.” For example, in August of 2010, Fed Chairman Ben Bernanke suggested that the Federal Reserve was considering engaging in a program of quantitative easing, wherein it would buy long-term Treasury bonds as a means of lowering interest rates and encouraging economic growth. An official announcement of the program came on November 3rd. Unemployment fell from 9.6 percent at the time of Bernanke’s speech to 9 percent in April of 2011 and the S&P 500 rose more than 30 percent over the same time period. As the economy began to recover, however, oil prices also began to increase, going from $68.34 in August of 2010 to $102.15 in April of 2011. According to Sumner, “as soon as oil started rising the Fed came under attack … [and as] the economy clearly was slowing in the spring of 2011, they went ahead with terminating QE2.”

Today this history may be repeating itself. With unemployment above 8 percent and long-term inflation expectations below the Fed’s target rate of 2 percent, the Fed’s mandate would seem to call for more expansionary actions. And in fact, the Fed is considering doing just that. Fear of future inflation, however, has caused several Fed members to call for greater restraint.