The Federal Reserve spent the past several years shifting to a policy framework that emphasizes employment more and inflation less. This made it more patient with business cycle expansions, which is one reason median household incomes grew more in the late 2010s than they did in the late 1990s.
But an unappreciated hero in facilitating this policy shift is the energy revolution that has transformed domestic energy markets.
For decades, one could argue, the Fed raised interest rates more in response to tight energy markets than tight labor markets. Because the U.S. has now achieved a certain kind of energy independence, those energy market constraints no longer exist as they did in the past, letting the Fed truly wait for signs of tight labor markets before raising rates.
To think about the benefits of a new era of energy abundance, it helps to begin by thinking about what happened when America first learned cheap energy wasn’t a sure thing, during the oil shocks of the 1970s. As my Bloomberg Opinion colleague Noah Smith points out, that was the decade when middle class workers started seeing their fortunes stagnate. The surge in oil prices that first began in 1973 had several negative impacts on American workers. For one thing, it squeezed their household budgets, boosting the percentage of their spending that went to energy consumption. Expensive oil was also bad for manufacturing, beginning a restructuring of the U.S. economy that eliminated factory jobs.
And because the economy was so dependent on foreign oil at the time, higher prices led to inflation, which the Fed eventually conquered by raising rates. But using monetary policy to weaken energy demand to cool off oil prices meant causing recessions, which resulted in higher unemployment for workers.
This cycle – faster economic growth boosting demand for imported oil and raising oil prices, fueling broad-based inflation or fears of it, leading to Fed rate hikes followed by recessions — arguably became the framework for thinking about U.S. economic expansions between the 1970s and the late 2000s.
Late in the cycle, when workers were finally benefiting from tight labor markets, was usually when oil prices were high enough to spook the Fed into raising rates. Workers rarely got monetary policy accommodation for long enough to experience the full benefits of an economic expansion.
But this wasn’t the case in the late 2010s. Oil prices did rise in late 2017 and early 2018 as the Fed was raising rates. But prices got nowhere near $100 per barrel, a level seen in 2008 and much of the first half of the 2010s.
That’s partly because fracking technology led to a surge in domestic oil production. Combine that with an economy that keeps getting more energy-efficient and is now enjoying steady growth and falling prices for renewables, and it’s debatable we’ll ever again see big oil-price surges late in economic expansions. This would be a welcome dynamic not seen in the U.S. economy since the 1960s.
For the Fed, this would mean its 2023 forecast of 4% unemployment, stable core inflation around 2% and short-term interest rates still at 0.1% should be achievable. No longer will it have to decide whether high oil prices or economic softness should dictate its policy choices — a dilemma it faced between 2006 and 2008, when energy prices were soaring but the housing market was slumping.
And this means workers should be able to reap the benefits of tight labor markets more often than they have over the past 40 years, without worrying policy makers will overreact to spikes in oil prices.
Because of the economic setback the pandemic dealt us, we don’t yet know whether 2019 labor conditions are the best we can achieve, or if something even better is possible. But thanks to the energy industry’s transformation, the next economic expansion could be our chance to find out.