In yesterday's post (Am I From Outer Space?) I alluded to the controversy concerning the role of monetary policy in alleviating or exacerbating the pain associated with energy-related supply shocks. In a recent Cleveland Fed Economic Commentary article, my colleagues Chuck Carlstrom and Tim Fuerst spoke directly to that question:
This Commentary discusses the efficacy of different federal funds rate movements in response to oil price shocks. Such movements may be direct responses to oil prices or, more likely, indirect responses. For example, a shock to energy prices tends to increase inflation,so that an inflation stabilization objective would lead to increases in the federal funds rate. To investigate the appropriate policy response, we must gain some idea of the differing economic impacts of oil prices and funds rate movements. Hence, this Commentary first discusses how to disentangle the contributions of oil price increases from those of funds rate increases. Some have argued that the problem is less the oil shocks per se than the Federal Reserve’s tendency to increase the funds rate (either directly or indirectly) in response to these shocks.
The article specifically addresses the findings of Bernanke, Gertler, and Watson I noted in the earlier post. The methodological details of Chuck and Tim's experiments will definitely be of interest to economists and students. But if that doesn't describe you, here is the bottom line:
Our experiments suggest that delaying further increases in the funds rate could help the economy through any potential “soft patch” caused by recent oil price hikes—without increasing the chance of inflation—but that the gains from such a change may be short-lived. Our anticipated-policy experiment demonstrates the downside of such a policy choice. The only reason that holding the funds rate constant substantially mitigated the output decline is that the public didn’t expect the Fed to do it. It might work once, but if the same response to oil price increases is given every time, it will eventually be anticipated by the public and do nothing to mitigate the output decline.