BOSTON (MNI) – The following is the second section of the text of
the remarks of Boston Federal Reserve Bank President Eric Rosengren
prepared Wednesday for the Massachusetts Chapter of NAIOP, the
Commercial Real Estate Development Association:

Some softness in measures of consumer confidence suggests that
consumers tend to be less confident about the future when oil prices
rise. If consumers pull back spending as a result of a supply shock, it
has the potential to be a drag on the economy. The Boston Fed’s
statistical modeling suggests that a $20 increase in the price of a
barrel of oil will shave roughly four-tenths of a percentage point off
the rate of economic growth over two years, and cause the unemployment
rate to be roughly two-tenths of a percentage point higher than it would
be absent the oil shock. While this is certainly not enough to
completely stop the recovery, it does imply a slowing down of its pace.

Oil is not the only commodity to experience price increases of
late. A variety of agricultural prices have also increased. For example,
Figure 3 shows the movement of wheat prices over the last decade.
Droughts in Russia, flooding in Australia, and increased demand in
emerging markets have all placed upward pressure on wheat prices.

As with oil prices, higher food prices appear to be responding to
supply and demand features of this market – and these types of price
changes cannot be offset by monetary policy. It goes without saying that
monetary policy cannot alter the supply of oil from volatile parts of
the world, nor weather conditions in countries that are major exporters
of agricultural products. Monetary policy can have a role in insuring
that relative price changes do not alter inflation expectations. Rising
inflation expectations could make it difficult to achieve a moderate and
acceptable inflation rate over the medium term.

Historical Experience with Supply Shocks

Supply shocks are not unique to this period. However, the evidence
shows that the economic impact of supply shocks on inflation has changed
over time – actually quite dramatically. Figure 4 shows the inflation
rate (total inflation and core, which again excludes food and energy)
since 1970. What is striking is the way the behavior of the two series
differed in the 1970 to 1985 period versus the period from 1986 to the
present. The interplay of core and total inflation is very, very
different in the more recent period than it was in the former. I realize
that delving into topics like total and core inflation can seem a bit
abstract. So let me bring in something a bit straightforward – energy
prices and inflation. Figure 5 shows the profound effect that energy
prices had in the 1970s on core inflation. In the 1970s the lines move
up and down together as core inflation increased with energy prices.
That is why my earlier chart shows core and total inflation moving so
closely in that era. But since 1986, dramatic movements in energy prices
have not affected core prices.

My next two figures look at each period separately. Figure 6 shows
that for much of that earlier period, inflation rates were much higher
than they are currently. From 1970 to 1985, inflation was quite volatile
– with total inflation (measured by the all-items Consumer Price Index
or CPI) peaking at almost 15 percent, in 1980. The key observation is
that during this period, increases in core inflation tended to follow
increases in total inflation (which includes food and energy). The oil
and food price increases “pulled” core inflation.

In contrast, Figure 7 shows the total and core inflation rates
since 1986. During this period, inflation has been lower and less
volatile. And unlike in the earlier period, core inflation does not
follow or gravitate to the level of total inflation. Total inflation
jumps up and down as food and energy prices live up to their reputation
for volatility. The spikes are tough on households, to be sure. But
importantly, total inflation eventually gravitates to the core measure
that excludes food and energy. Core inflation stays “moored.”

Figure 8 represents another way to use the available data to
explore this relationship. It too shows that the increases in total
inflation in recent years have generally been temporary. For each
quarter from 1998 to 2010, the figure plots the difference between total
inflation and core inflation at the time, and the total inflation rate
two years later. What it shows is that when there is a supply shock such
that total inflation (including food and energy) exceeds core inflation,
two years later total inflation tends to be lower – when supply shocks
such as oil prices drive up total inflation relative to core, the total
tends to come back down toward the core inflation rate.

Figure 9 performs similar analysis but focuses on the future core
inflation rate, instead of the total. It shows no strong relationship.
When total and core inflation diverge, core inflation tends to stay put.
In other words, in recent years, when something like an oil shock causes
total inflation to diverge from core, there was no consistent
implication for the future core inflation rate. The shock to total
inflation did not become embedded in core inflation.

Why is all this important? If supply shocks tend to have a
transitory impact on headline inflation, and do not pass through to any
meaningful extent into core inflation, then monetary policy need not
respond to the price increases caused by the supply shock. Currently, we
have experienced sharply higher food and energy prices. If the
relationship we document over the last 13 years continues, we should
expect the impact on inflation to be transitory – and that total
inflation will converge back to core inflation, which remains well below
2 percent.

To digress, it is likely the case that supply shocks have become
transitory because of the way in which monetary policy has tended to
respond. So, as long as monetary policy behaves about as it has in
recent years, then there is no reason to expect supply shocks to have
lasting effects.

So is Fed policy behaving as it has since the mid 1980s?
Interestingly, although Fed policy is perceived as exceptionally
accommodative, because of hitting the zero lower bound the federal funds
rate is actually higher – has come down less – than would be expected if
the Fed behaved as it has over the last 25 years. The current level of
the funds rate suggest that we have been less accommodative in recent
years given that interest-rate reductions (policy easing) ran into at
the zero lower bound.4

Why the Different Reaction to Supply Shocks Over Time? But how
confident should we be that the relationship we have experienced over
the past 25 years – little response in medium term inflation rates to
supply shocks – will continue? The answer is rooted in why we are seeing
different reactions to supply shocks – in other words a different
interplay of total and core inflation – now versus in the past.

There are a variety of reasons why medium-term inflation has not
been significantly influenced by short-run supply shocks in recent
years. In my view the reasons include the increased role of services in
the economy, the importance of labor costs in such an economy, the
reduced share of oil consumption relative to GDP, and as I mentioned
earlier the improved conduct of monetary policy versus the 1960s and
1970s.5

Figure 10 shows that the service sector has grown from a little
over 60 percent of private sector employment in 1970 to a little over 80
percent in 2010. As the economy has come to emphasize services versus
manufacturing, it may be that commodities (and thus their prices) have
become somewhat less important to the production of goods and services.
And goods prices are more volatile than services prices, and more likely
to be priced like commodities. Figure 11 shows the per capita
consumption of oil declining in the United States. Conservation measures
by consumers and businesses have made the economy less dependent on oil
than in the 1970s. While oil remains a very important commodity, the
trend towards reducing dependence on oil provides greater insulation
from oil-induced supply shocks.

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