Another Problem with the Anti-Core Argument

Following up on my previous post, I want to make an empirical point about Caroline Baum’s argument. She argues that a long lag cannot explain the failure of non-oil prices to adjust downward in the face of rising oil prices:

You might counter by saying that the price of something else will fall with a lag, not simultaneously; that when gas prices go up the consumer doesn't immediately cut back on his non-oil purchases.

Let's go to the video tape. The consumer price index was running at about 2 percent year-over-year during the deflation scare in the middle of 2003. Crude oil prices were hovering near $30 a barrel.

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.

But there’s a problem here (beyond the theoretical problems mentioned in my previous post). First of all, nobody disputes that the Fed was accommodating the oil price increases in 2003 and 2004. So it shouldn’t surprise anyone that non-oil prices failed to adjust during 2005 and the first half of 2006. At the time (2003 and 2004), the Fed had legitimate concerns about a soft economy, but the economy subsequently proved to be stronger than the Fed had feared. It turned out that the intentional easy money policy of 2002 and 2003 had been successful.

As 2005 went on, however, the Fed stopped accommodating the oil price increases, and in 2006, the Fed has even started pushing the other way. This is where the lag comes in. Because there really is a lag in the behavior of consumers, we won’t know until 2007 (or maybe even 2008) whether the oil price increases (which continued through 2005 and the first half of 2006) have reduced demand in the rest of the economy, as Ms. Baum would expect if the Fed were behaving itself. My guess is that, when all the votes are in, we will find that inflation has lost and that the Fed was right to ignore the direct effect of oil prices.