Do Oil Shocks Have Any Predictive Value?

By Grant de Graf

James Hamilton, a Professor of Economics at the University of California, San Diego, has recently completed a paper showing the correlation between oil shocks and economic recessions. The publication is impressive and demonstrates the strong relationship between oil shocks and the business cycle. The real question is whether the data can be of predictive value in forecasting peaks and troughs of a business cycle from the implied correlation. In other words, are the oil shocks a function of economic recessions [or the boom that precedes a recession] or is an economic recession a consequence of an oil shock?

[click on chart to enlarge]

Hamilton concludes from his paper: "The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence (Hamilton, 1983a, 1985). And although demand pressure associated with the later stages of a business cycle expansion seems to have been a contributing factor in a number of these episodes, statistically one cannot predict the oil price changes prior to 1973 on the basis of prior developments in the U.S. economy (Hamilton, 1983a). Moreover, supply disruptions arising from dramatic geopolitical events are prominent causes of a number of the most important episodes. Insofar as events such as the Suez Crisis and first Persian Gulf War were not caused by U.S. business cycle dynamics, a correlation between these events and subsequent economic downturns should be viewed as causal. This is not to claim that the oil price increases themselves were the sole cause of most postwar recessions. Instead the indicated conclusion is that oil shocks were a contributing factor in at least some postwar recessions."

In an attempt to disassociate the oil shocks from the business cycle, the paper uses the examples of the Suez Crisis and the Persian Gulf War, as specific incidents that preempted a downturn. The study thus concludes that oil shocks do contribute to recessions, but acknowledges that their impact is not absolute.

Historically, strong demand for crude evident at the peak of a cycle, has played a significant role in price escalation. One ponders over whether [bar for the Suez Crisis and Persian Gulf War] the majority of oil shocks were not just a function of business cycle peaks that ultimately evolved into a downturn, as a natural consequence of the business cycle. Irrespective, what is strikingly evident from this paper, is that oil prices may be an efficient mechanism in which to measure the peak of a cycle.