What the Saudi oil shock tells us about monetary policy
By Scott Sumner
When I do PowerPoint presentations on monetary policy, I often explain level targeting with an analogy from the oil industry. Suppose oil output was suddenly reduced by technical problems in Saudi Arabia, but the disruption was expected to be temporary. In that case, oil prices would rise by much less than if the exact same reduction is supply was expected to be permanent.
If oil production declines for only a brief period, the producer can commit to restoring oil prices to their target level after the problems are fixed. That commitment will tend to prevent prices from rising very much, even during a period of supply disruption. If the normal price were $50/barrel, then a rise to $53 might lead wholesalers to release oil from their inventory, with the expectation that they’d later restock at lower oil prices after production was restored. Here the key assumption is that the “swing producer” has a credible commitment to maintain stable oil prices in the long run.
I use this example because something very similar occurs with level targeting. If the central bank is credibly targeting gold or foreign exchange prices, then a temporary shock will have little impact, as traders know that prices will soon return to the target range.
And this explains why NGDP level targeting is so desirable. Under level targeting, a temporarily disruption like Brexit, or a trade war, has little impact on NGDP due to the central bank’s commitment to eventually return nominal spending to the target path. Strong expected future growth keeps companies from abandoning projects during a period of temporarily depressed demand. It creates what Keynes called “animal spirits”. As a result, demand doesn’t fall by as much, even in the short run.
But does this “expectations fairy” actually work? The recent Saudi oil shock suggests that the answer is yes. On September 16 of this year, attacks on Saudi oil infrastructure temporarily cut production roughly in half. Normally, that would cause a huge spike in prices, as the demand for oil is pretty inelastic. And prices did surge on the 16th, along with reports that the damage might take “weeks” or “months” to fix.
Soon after, it became apparent that the disruption would not last as long as many feared, and oil prices almost immediately fell back by $5 barrel. Thus the price increase ended up being much smaller than the initial shock, because investors understood that inventories could meet demand during the repair period, and that once oil production was restored the Saudis would be able to ramp up production and normalize the market.
Under level targeting, it’s important to try to get NGDP back to the trend line as soon as possible. It would do no good today to try to restore NGDP to the pre-2008 trend line—too much time has gone by. Instead, central banks should promise that if there is a recession in 2020, they will do whatever it takes to get the price level (or better yet NGDP) back up to trend by 2022. That promise will make any recession much milder, even if monetary policy were powerless during the recession itself. (And it isn’t powerless.)
PS. President Trump has recently called for zero interest rates. Although I understand the logic of his argument, I believe he’s making a mistake. Zero interest rates are likely to occur if there is very weak NGDP growth. Instead, he should be calling for a monetary policy that will generate a healthy economy without the need for zero interest rates. He should call for level targeting.