Oil, the Economy, and the Stock Market

20 Pages Posted: 25 May 2008

Date Written: April 2008

Abstract

We quantify the time-varying effects of oil-price shocks on the U.S. economy, Federal Reserve policy, and global equity markets. While the first-round impact of oil-price shocks on U.S. economic growth has not changed materially over time, their formerly-negative second-round effects are notably absent over the past 25 years given oil's near-zero impact on long-term inflation expectations. Since oil-price shocks now represent a less-stagflationary policy tradeoff, we show why the Federal Reserve should lower short-term interest rates in response to an oil-price shock under certain (but not all) macro scenarios. For domestic and international stocks, simple regressions reveal the anticipated inverse relationship, with a 10% increase in oil prices associated with a statistically significant 1.5% lower total return. However, the stock market's reaction varies dramatically depending on the source of the oil-price shock, with global stocks - in particular the industrial and materials sectors - responding quite favorably to oil-price increases attributed to global-demand shocks. A key implication is that oil-price increases do not uniformly lead to lower stock returns. Interestingly, our oil-price decomposition suggests that oil's recent surge cannot be explained by supply disruptions, global demand fundamentals, or the depreciation of the U.S. dollar.

Keywords: Oil, macroeconomy, stock market, inflation expectations, Federal Reserve

JEL Classification: E30, E60, G12

Suggested Citation

Davis, Joseph H. and Aliaga-Diaz, Roger A, Oil, the Economy, and the Stock Market (April 2008). Available at SSRN: https://ssrn.com/abstract=1136524 or http://dx.doi.org/10.2139/ssrn.1136524

Joseph H. Davis (Contact Author)

The Vanguard Group ( email )

100 Vanguard Blvd
Malvern, PA 19355
United States

Roger A Aliaga-Diaz

The Vanguard Group, Inc. ( email )

100 Vanguard Blvd
Malvern, PA 19355
United States

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