One of Kilian’s contributions is to develop a new time series based on the changes in the dollar price per ton of dry cargo shipping, displayed below. Tim Duy is among those already making use of the related Baltic Dry Freight Index. Shipping rates often start to climb sharply in the later stages of an unusually long or strong global economic boom, because of the long lead time required to build new ships. This index shows several upward surges in the 1970s and a more recent climb during 2003-2005.
Since mining is also subject to long lead times, Kilian’s series gives a useful way to measure the contribution that variations in the level of global aggregate demand may make to commodity prices generally. Kilian looked at the extent to which fluctuations in the real price of oil could be explained statistically by the deviation of the series above from the CPI and a long-term time trend. The resulting predicted oil price swings are given in the middle panel below. The top panel isolates oil price changes that would be predicted on the basis of fluctuations in the total quantity of oil produced, while the bottom panel tracks the residual. Kilian labeled this third series as the effect of “oil-specific demand shocks”, thinking of events such as the response of speculators to concerns about the possible future supply disruptions that could have resulted from Iraq’s invasion of Kuwait in 1990.
Kilian concludes that oil supply disruptions have been less important than either of the other two factors in accounting for movements in the real price of oil. He attributes the broad trends of falling real oil prices in the 1990s and the run-up since 2001 primarily to global aggregate demand, whereas he believes that the sharp price spikes in 1979-80 and 1990 resulted from speculative demand.
Kilian then goes on to show that while oil price increases that result from supply disruptions or speculation tend to depress U.S. GDP, oil price increases that result from global demand factors are actually associated with stronger U.S. real GDP growth in the first year of the shock, though they later can be followed by slower GDP growth. Kilian also finds that demand-led oil price increases appear to be associated with an increase in U.S. inflation rates.
In other words, inflation, not recession, should have been the Fed’s major concern about the effects of oil prices during 2005.
For the record, my main concern in 2005 was recession, not inflation. And I was wrong.
Also for the record, my main concern in 2007 is still recession, not inflation.