High Oil Prices Will Not Cause Inflation or a Recession

When oil prices really started to rise a few years ago many economists predicted that the higher oil prices would translate into higher inflation levels and slower economic growth, with more than a few predicting that high oil prices would cause a recession. In response to such ignorant thinking, I wrote the following:


High Oil Prices and Economic Growth

No matter how high oil prices go, when we go to the pump or use oil in any other way, a business transaction is taking place. Economic activity is continuing. Money may be diverted from other transactions to pay for the higher oil prices, but economic activity does not stop.

Economic activity stops when the amount of money in circulation changes, specifically, when the growth rate of money in circulation slows or stops dramatically. Higher oil prices do not effect the amount of money in circulation, or the growth rate of money in circulation. So higher oil prices will not cause economic activity to stop. Higher oil prices, in and of itself, will not cause a recession.

In the 1970’s, the Federal Reserve, due to higher oil prices, inflated the amount of money in circulation. The Fed did this because the leaders at that time believed that in order to pay the higher oil prices there had to be more money in circulation in the economy. All this mistaken logic did was to cause inflation. When the inflation came the Fed stopped inflating the money supply and a recession followed. It was the Federal Reserve’s dramatic slowing of money growth which caused the recession.

No matter how high oil prices go, inflation will not occur unless the Federal Reserve inflates the amount of money in circulation. The higher inflation of the 1970’s was not caused directly by higher oil prices, but by the mistaken policy decisions made by the Federal Reserve at that time regarding higher oil prices.

- October 5, 2004