Aug. 2004 — Q: (Will higher) oil prices (bring) inflation or a drag on the economy? Recent articles seem to indicate it will do both if it goes really high. How can we have inflation when the economy is not growing and therefore creating jobs and pushing wages up? — Rod M., Austin, Texas
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A: In theory, higher oil prices can bring both higher inflation and lower economic growth. That's what happened in the 1970s, when the first "oil shock" gave economists a new piece of jargon: stagflation, which had nothing to do with bachelor parties. (A stagnating economy with high inflation = stagflation.) What made stagflation so difficult to deal with was that the usual levers at the Fed don't work very well. Higher interest rates cut inflation, but they also throw more cold water on the economy. Lower rates help spur growth, but they add fuel to the inflation fire.
This time around, however, the economy is growing, according to the government's latest report on Gross Domestic Product. But that growth is coming primarily from increased productivity — not from newly-hired workers. What's not clear is whether all the increased productivity is the result of technology helping us all become more efficient — or whether we're all just turning into round-the-clock slaves to that technology. In other words, are we working smarter or harder?
As for inflation, there are two kinds: price inflation and wage inflation. Price inflation generally comes first, often from shortages of critical commodities (like oil). Those higher prices then squeeze workers' buying power, so they go to their bosses and demand pay raises (or threaten to strike). To pay for those raises, companies raise the prices of their goods and services, which then sends workers back for more raises, and the vicious cycle begins. That's what happened during the Great Inflation of the 1970s.
With today's employment outlook uncertain and job security reduced, workers are more reluctant to demand those raises. So far, we've only seen the beginning of the impact of higher oil prices. If companies begin to pass those higher costs along (oil is used to make or ship just about everything we consume), eventually workers will start squawking.
Still, there are several big differences between today and the 1970s. For one thing, U.S. taxpayers just got a big tax cut last year, which boosted buying power. Second, when adjusted for inflation, oil prices really aren't as high as they were in the 1970s. And perhaps most important, the oil shock of the 1970s created a huge national effort to become more energy efficient. The result is that the amount of oil used to produce each dollar of GDP is about half what it was 30 years ago.
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