The oil price shock of the 1970s began in October 1973 when, in response to the Yom Kippur War, Arab oil producers imposed an embargo on exports. Before the embargo, in 1972, the price of imported oil was about $3.20 per barrel; by 1975, the average price was nearly $14 per barrel, more than four times greater. President Nixon had imposed economy-wide controls on wages and prices in 1971, including prices of petroleum products; in November 1973, in the wake of the embargo, the President placed additional controls on petroleum prices.²

As basic economics predicts, when a scarce resource cannot be allocated by market-determined prices, it will be allocated some other way--in this case, in what was to become an iconic symbol of the times, by long lines at gasoline stations. In 1974, in an attempt to overcome the unintended consequences of price controls, drivers in many places were permitted to buy gasoline only on odd or even days of the month, depending on the last digit of their license plate number. Moreover, with the controlled price of U.S. crude oil well below world prices, growth in domestic exploration slowed and production was curtailed--which, of course, only made things worse.

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Fast-forward now to 2003. In that year, crude oil cost a little more than $30 per barrel.³ Since then, crude oil prices have increased more than fourfold, proportionally about as much as in the 1970s.  Now, as in 1975, adjusting to such high prices for crude oil has been painful. Gas prices around $4 a gallon are a huge burden for many households, as well as for truckers, manufacturers, farmers, and others. But, in many other ways, the economic consequences have been quite different from those of the 1970s. One obvious difference is what you don't see: drivers lining up on odd or even days to buy gasoline because of price controls or signs at gas stations that say "No gas." And until the recent slowdown--which is more the result of conditions in the residential housing market and in financial markets than of higher oil prices--economic growth was solid and unemployment remained low, unlike what we saw following oil price increases in the '70s.

We estimate ... that every $10 increase in the cost of a barrel of oil reduces the real GDP somewhere between two-tenths and perhaps as much as a half a percentage point.

At a conservative level, that means that we have taken at least another percentage point off on a national scale in terms of real gross domestic product.

As reported by Reuters

 [R]ising energy prices have sapped consumer and business spending. Because so much of our oil is imported, an increase in oil prices effectively acts as a tax on consumer and business spending.

Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

[H]igher oil prices caused by productivity gains have a much different effect on the economy than oil supply shocks. A productivity shock originating in the U.S. will boost our economic output, and the expansion will pull up the price of oil. If monetary policy holds the growth of nominal GDP constant, this will result in a reduction of inflationary pressures. If China or India or some other country is expanding rapidly and it is the country's oil consumption that is increasing, driving up prices, that surge in productivity can yield spillovers for the U.S. in the form of lower import prices and technological gains. As long as this continues, we can expect to see an expansion of output and lower overall prices, even as the world price of oil rises. A vicious cycle is, in a sense, almost transformed into a virtuous cycle.

With each uptick in energy prices, I ask whether it is supply or demand that is making prices rise. Supply disruptions are cause for concern, but growth in demand is not as worrisome. Most likely, energy prices will continue to be volatile; it is the nature of the beast. The same goes for food prices.

The economy has performed well despite a near tripling of crude oil prices since December 2001. In years past, an energy price shock of this magnitude was typically associated with a substantial increase in inflation and a sharp recession.

Two things are different about energy price increases this time. One is that the increases were primarily a consequence of a booming world economy, which raised energy demand rather than a supply shock. Second, monetary policies here and in most other countries have done a fine job of anchoring inflation expectations.

With oil prices persistently above $70 a barrel, households and businesses face new costs that must be absorbed, offset, or passed along if possible. Although difficult to measure, these higher energy costs have forced households to reallocate spending and could dampen consumer spending in the future.

Rising energy prices pose risks to both economic activity and inflation. If energy prices stabilize this year, even at a high level, their adverse effects on both growth and inflation should diminish somewhat over time. However, as the world has little spare oil production capacity, periodic spikes in oil prices remain a possibility.

In particular, we do expect to see a slight slowing in growth, perhaps a couple tenths, this year and next, associated with the higher oil prices and their effects on consumer spending.  And we are very aware of that and are paying attention to those developments.

A rough estimate puts the reduction in real GDP growth from the increases in energy prices since late 2003 at between 1/2 percent and 1 percent per year.

The surge in energy prices since late 2003 has significantly reduced the purchasing power of households and decreased the profits of non-energy firms, thereby restraining both consumer spending and business investment. By rough estimate, these increases in energy prices have probably reduced real GDP growth between 1/2% and 1% per year over this period. Although some of this loss in output will be made up in the longer run as the U.S. economy adjusts to higher energy prices, the level of productivity is likely to remain lower than it otherwise would have been, as firms use less energy per worker.

Overall, the fundamentals appear sufficient to support continued economic expansion. Underlying productivity growth remains strong, the financial positions of households and businesses remain conducive to spending, and, if we have no further run-up in oil prices, the drag on activity from higher energy prices should diminish over time.

Although they are imprecise, simulations from the Federal Reserve Board staff's large-scale econometric model, which account for these effects, suggest that increases in spot and futures prices of energy from late 2003 to the present subtracted a 1/2 percentage point from real GDP growth in 2004 and more than 1 percentage point in 2005. The model suggests the subtraction this year will be about a 1/2 percentage point.

We simulated FRB/US using the path for crude oil prices that futures market participants in December 2003 expected to prevail over the following three years. We also simulated the model with the revisions to futures prices that occurred subsequently over 2004 and through mid-September of this year. Based on a comparison of these simulations, we estimate that real GDP growth was held down 1/2 percentage point in 2004 and 1 percentage point this year relative to what it otherwise would have been. The drag on real GDP growth next year would be comparable to that in 2004. As higher energy prices are passed through to the prices of other goods and services, prices for core personal consumption expenditures (core PCE) are estimated by the model to have been boosted 1/4 percentage point last year and more than 1/2 percentage point in 2005. Given the lags in the inflation process, core PCE inflation rises a bit further relative to baseline next year.

Thus far at least, the growth effects of energy price increases appear relatively modest. The economy is much more energy-efficient today than it was in the 1970s, when energy shocks contributed to sharp slowdowns, and real energy prices remain below the peaks attained in the 1970s and early 1980s. Well-controlled inflation and inflation expectations have also moderated the effects of energy price increases, since those increases no longer set off an inflation spiral and the associated increases in interest rates, as they did three decades ago.