Oil Prices, Monetary Policy, and the Macroeconomy - Disentangling Oil Price Hikes and Funds Rate Hikes

Sep 21, 2026

Uploaded by Liam

Recessions are linked to rising oil prices and increases in the federal funds rate, prompting the question of whether oil price spikes, monetary tightening, or a combination drives downturns. The commentary reviews two strategies—empirical and theoretical modeling—to separate these effects and evaluate a counterfactual where the Federal Reserve keeps the funds rate constant after an oil shock. It argues expectations can undermine purely empirical counterfactuals, while theory suggests a one-time deviation may help but repeated deviations would be ineffective once anticipated.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages5

Reading Time13 min

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Recessions, Oil Prices, and Monetary Policy

Disentangling Oil Price Hikes and Funds Rate Hikes

Empirical Estimates and Counterfactuals

Role of Expectations and Policy Anticipation

by Charles T.Carlstrom and Timothy S.Fuerst preceded by increases in the price of oilanda rise in the federal funds rate(figure 1).Are recessions caused byspikes in oil prices or by a sharp tighten-ing of monetary policy?Or are theycaused by a confluence of both factors,the so-called “perfect storm? This Commentary discusses the efficacyof different federal funds rate move-ments in response to oil price shocks.Such movements may be directresponses to oi pricesor,more likely,indirect responses.For example,a shockto energy prices tends to increase infla-tion,so that an inflation stabilizationobjective would lead to increases in thefederal funds rate.To investigate theappropriate policy response,we mustgain some idea of the differing eco-nomic impacts ofoil prices and fundsrate movements.Hence,this Commen-tary first discusses how to disentanglethe contributions of oil price increasesfrom those of funds rate increases.Somehave argued that the problem is less theoil shocks per se than the FederalReserve's tendency to increase the fundsrate(either directly or indirectly)inresponse to these shocks. There are two approaches to disen-tangling the impacts of oi prices andfunds rate movements on the typicalrecession:empirical modeling and theo-retical modeling.Both of them attemptto answer the counterfactual question,"How much would output have fallen ifthe Federal Reserve had kept the fundsrate constant in the wake of the oil priceshock?"We argue that the empiricalapproach,which has formed policy dis-cussion,does not handle expectations Oil Prices,Monetary Policy,and theMacroeconomy very well.Empirical work estimateschanges based on historical data,butthese data are formed by the public'sexpectations of how the Fed willbehave.If these expectations were tochange,however,the future might bevery different from the past.That is,the empirical approach toanswering the counterfactual questioninvestigates how far output would havefallen after an oil shock,under theimplicit assumption that the publicexpects interest rates to increase inresponse to that oil shock,as they havein the past.The public is thus surprisedwhen the Fed keeps the funds rate con-stant in the wake of the oil shock.But ifthe Fed were to stop responding to oilshocks,and the public understood thispolicy change,the answer to the counter-factual question might be far differentUsing a theoretical model to addresstheeffect of such an anticipated policychange,we conclude that deviatingonce,and not allowing the funds rate toincrease,could have some advantageouseffects.But it would be unwise todeviate repeatedly,because once sucha policy is anticipated,the presumedoutput gains of the constant funds ratepolicy disappear. # ■ Disentangling Oil Price Hikesand Funds Rate Hikes In an influential article,economistsBernanke,Gertler,and Watson(BGW)approached the issue of how to disen-tangle oil and funds rate increases byasking the counterfactual question,"How much would output have fallen ifthe Federal Reserve had kept the fundsrate constant in the wake of the oil priceshock?"Asa first step,BGW estimate July 2005 Recessions are associated with bothrising oil prices and increases in thefederal funds rate.Are recessionscaused by the spikes in oil prices orby the sharp tightening of monetarypolicy?The authors discuss how todisentangle these two effects. how the economy typically behaves ifboth oil and the funds rate increase.(Some economists have questionedwhether BGW's estimates remain validor stable in the most recent period,from1983 to the present) Figure 2 contains BGW's empirical esti-mates of the impact a 10 percent oilprice shock would have on GDP if thefunds rate increased with oil price hikes.Because oil price changes tend to haveasymmetric effects,BGW focus only onoil price increases that exceed anythingexperienced over the previous fourquarters.The analysis suggests that aone-time increase in oil prices and theensuing funds rate increase would lowerGDP by 0.7 per

FAQs

Why do recessions correlate with both oil prices and the federal funds rate?

Recessions coincide with rising oil prices and tightening in monetary policy, raising the question of whether oil spikes or interest-rate hikes—and their interaction—drive output declines.

How do empirical and theoretical approaches differ in separating oil and funds-rate effects?

Empirical modeling uses historical data to infer impacts, but the commentary notes these data reflect public expectations about the Fed. Theoretical modeling incorporates anticipated policy responses, allowing a clearer counterfactual when the Fed changes its reaction.

What does the analysis suggest about holding the funds rate constant after an oil shock?

Using a theoretical model for an anticipated policy change, the commentary concludes that deviating once—by not increasing the funds rate—could have advantageous effects, though repeated deviations become unhelpful once expectations adjust.

Sep 21, 2026

Uploaded by Liam