Media Briefings

Oil Prices And Monetary Policy: New Research Evidence

  • Published Date: September 2011

The US Federal Reserve did not cause the recessions of the 1970s and early 1980s by
raising interest rates in response to unexpectedly higher oil prices. Moreover, the oil price
‘shocks’ contributed comparatively little to the output and inflation swings of those decades.
These are among the conclusions of research by Professor Lutz Kilian and Logan Lewis,
published in the September 2011 issue of the Economic Journal.
The researchers note that the effects of monetary policy responses to oil price shocks in the
1970s and early 1980s should not be only of interest to economic historians. The issue is
central in modern day analysis of the transmission of oil price shocks, with some observers
suggesting that the Fed may have been too passive in dealing with the drivers of high asset
and oil prices after 2005.
What’s more, as the world economy recovers from the crisis, the question of how to
respond to higher oil prices is likely to take on a new urgency. In a policy environment that
resembles the beginning of the 1970s, understanding the monetary policy regimes of that
era – to what extent they were successful and to what extent they can be improved – is
crucial for monetary policy-makers.
Oil prices since 1970 have been volatile and the subject of both media and academic
attention. But while they are important for businesses and consumers alike, even large oil
price swings on their own are unable to generate major booms and busts in the overall
This led some economists to propose that in addition to the direct effect of oil price
increases, the Fed might raise interest rates to fight the inflationary effects of oil price
shocks. This policy reaction would amplify the direct effects of the oil price increases – and
together these effects would cause a recession.
Kilian and Lewis show that the evidence for this channel rests largely on using only oil price
increases, rather than both increases and decreases in the price of oil. By ignoring oil price
decreases, the statistical estimate of the effects of unexpected changes in oil prices is
overstated. Without this questionable transformation, their research shows, oil price shocks
did not significantly contribute to the inflation and output movements of the 1970s and early
1980s, even when the monetary policy response is included.
Monetary policy responds to many economic variables, most notably inflation and real
economic activity. Kilian and Lewis estimate and decompose the response to an
unexpected 10% increase in the real price of oil. They find that the overall Fed Funds rate
rises about 0.6% after six months.
Most of this response is directly triggered by the oil price increase itself, indicating that the
Fed was indeed responding to oil price shocks. But relative to other shocks in the economy,
these oil price shocks are too small to cause the booms and busts seen in past decades,
and the monetary policy response does not substantially amplify these effects.
Moreover, Kilian and Lewis caution that all oil price changes are not alike. Some are
caused by supply disruptions, including wars and decisions by OPEC. Others are the result
of shifts in worldwide demand for energy, undermining the rationale for a mechanical policy
response to oil price shocks.
In addition, there is evidence that the monetary policy response to oil price shocks has
changed since the 1980s. Future models of oil and monetary policy should analyse the
underlying sources of oil price changes, with monetary policy responding to those causes
rather than the resulting price effects.
Notes for editors: ‘Does the Fed Respond to Oil Price Shocks?’ by Lutz Kilian and Logan
Lewis is published in the September 2011 issue of the Economic Journal.
Lutz Kilian is at the University of Michigan and CEPR. Logan Lewis is at the Federal
Reserve Board.
Disclaimer: The views expressed here are solely the responsibility of the authors and
should not be interpreted as reflecting the views of the Board of Governors of the Federal
Reserve System or other members of its staff.
For further information: contact Romesh Vaitilingam on +44-7768-661095 (email:; Lutz Kilian on +1-734-647-5612 (email:; or
Logan Lewis via email: