Oil Price Rise May Be Cause For Concern
Jan. 27, 2000

With oil prices inching towards $30 a barrel, is inflation about to rear its ugly head once again?

Ever since the twin oil crises of the 1970s, policy makers and businesses alike have dreaded the specter of higher oil prices. The transportation industry is the first to feel the impact: higher prices for gasoline and jet fuel immediately translate into higher operating costs and diminished profits for the trucking and airline companies. The effects of the rise in transportation costs may then ripple throughout the economy as the myriad firms that employ transport services for supplies, distribution and travel now find these services to be more expensive. In a bid to recoup this increase in costs, firms may resort to raising the prices of their goods and services -- causing, in all likelihood, a surge in inflation.

It was about 10 years ago that we last witnessed a spike in the price of oil. The outbreak of the Gulf War had raised fears about a reduction in the supply of oil to global markets, causing prices to climb markedly. The result then? Higher inflation, accompanied by an economic slowdown.

But this time things seem to be different. In recent months, as the price of oil breached the $20-per- barrel mark, then the $25 mark and now flirts with $30 a barrel, most analysts appear to be largely unperturbed. Instead of the consternation that might have greeted the phenomenon just a few years ago, now the response borders on indifference.

What gives?

We live in a New Economy, say some insouciantly, in which the old rules no longer apply. Two developments have weakened oil's stranglehold on the economy, argue the New Economists: first, today's economy is increasingly technology-driven, and as such, it has less use for energy than the grimy manufacturing economy of yore. Second, firms have become highly energy-efficient, thus insulating themselves from spikes in oil prices.

Is this view justified? Should we shrug off the rise in oil prices as inconsequential?

There are good reasons for adopting a somewhat skeptical stance. While technology's growing role in the economy cannot be gainsaid, it is far from clear that the old standbys of delivering supplies, distributing goods, and employee travel have disappeared, or even shrunk in importance. Buy a book from Amazon.com and see: who delivers the book to your door? If oil prices remain stubbornly high, delivery firms like UPS and FedEx will assuredly raise their prices.

As far as the second argument is concerned, it is true that investments in energy-efficient methods of production have reduced firms' reliance on energy. Yet, as with any other input, a steep and sustained rise in the price of oil will adversely affect the profitability of firms and lead them to raise the prices of their products and curtail production.

Mr. Alan Greenspan, Chairman of the Fed, whose job it is to ensure that inflation stays dormant, concedes that the economy has undergone a remarkable transformation in recent years. Productivity growth, which had all but disappeared in the 1970s and only made a lackluster appearance in the 1980s, appears to have made a surprisingly strong comeback in the last decade. Carried triumphantly aloft the rapid technological advances of the decade, this robust growth in labor productivity has kept inflation at bay while the U.S. economy forged steadily ahead, adding a couple of million new jobs each year and driving unemployment down to levels rarely seen in the last three decades.

Of course, in evaluating the factors responsible for the longest economic expansion in U.S. history, one would be churlish in denying the importance of Greenspan's judicious conduct of monetary policy -- and the fact that oil prices remained agreeably low during the period. With the latter now a thing of the past, will analysts continue to adopt a sanguine outlook on inflation?

The evidence from the financial markets is telling. In the past few months, long-term bond yields have risen appreciably, signalling higher expected future inflation. If the labor market continues to generate jobs with unmitigated fervor and the price of oil snakes skyward alarmingly, will the Fed leave short-term interest rates alone? The financial markets have already braced themselves for an increase -- the only question now is: How much?