Oil prices, monetary policy, and the macroeconomy

Every U.S. recession since 1971 has been preceded by two things: an oil price shock and an increase in the federal funds rate. Bernanke, Gertler, and Watson (1997,2004) investigated how much oil price shocks have contributed to output growth by asking the following counterfactual question: Empirically how much would we expect oil price increases to have contributed to output growth if the Fed had kept the rate constant instead of letting it increase? They concluded that, at most, half of the observed output declines can be attributed to oil price increases. Most were actually caused by funds rate increases. A problem with their empirical analysis, however, is that it implicitly assumes that the Fed can continually fool the public. That is, the funds rate is led constant even though the public actually expects the Fed to follow its historical policy rule of raising the funds rate in conjunction with oil price increases. We show that if the new policy rule were anticipated oil price increases would have had a much larger impact on output than suggested by Bernanke, Gertler, and Watsons analysis.