1990 oil price shock
The 1990 oil price spike occurred in response to the Iraqi invasion of Kuwait on August 2, 1990. Lasting only 9 months, the price shock was less extreme and of shorter duration than the previous oil crises of 1973 and 1979-1980, yet the rise in prices is widely believed to have been a significant factor in the recession of the early 1990's.Average monthly prices of oil rose from $17 per barrel in July to $36 per barrel in August.As the U.S. led coalition experienced military success against Iraqi forces, concerns about long-term supply shortages eased and prices began to fall.
Iraqi Invasion of Kuwait and Ensuing Economic Effects
On August 6, 1990, The Republic of Iraq invaded the State of Kuwait, leading to a 7-month occupation of Kuwait and an eventual U.S. led military intervention. While Iraq officially claimed that Kuwait was stealing its oil via slant drilling, its true motives are more complicated and less clear. At the time of the invasion Iraq owed Kuwait $14 billion of outstanding debt that Kuwait had loaned it during the Iraq-Iran war. In addition, Iraq felt that Kuwait was overproducing oil, lowering prices and hurting Iraqi oil profits in a time of financial stress. In the buildup to the invasion Iraq and Kuwait had been producing 4.3 million barrels of oil a day. This potential loss, coupled with threats to [[Saudi Arabian]] oil production, led to a rise in prices from $21 per barrel at the end of July to $28 per barrel on August 6. On the heels of the invasion, prices rose to a peak of $46 per barrel in mid-October.
The United States’ rapid intervention and subsequent military success helped to mitigate the potential risk to future oil supplies, thereby calming the market and restoring confidence. After only three quarters, or 9 months, the spike had subsided.
U.S. Policy Response
The U.S. Federal Reserve’s monetary tightening in 1988 targeted the rapid inflation of the 1980’s. By increasing the federal funds rate and lowering growth expectations the Fed hoped to slow and eventually reduce inflationary pressures, creating greater price stability. The August 6 invasion was seen as a direct threat to the price stability that the Fed sought. In fact, the Council of Economic Advisors published a consensus estimate that a one-year 50 percent increase in the price of oil could temporarily raise the price level of the economy by 1 percent and potentially lower real output by the same amount.
Despite the potential for inflation, the U.S. Fed and central banks around the globe decided that it would not be necessary to raise interest rates in order to counteract the rise in oil prices. Rather, the U.S. Federal Reserve decided to maintain interest rates as if the oil price spike was not occurring. This decision to refrain from action stemmed from confidence in the future success of Desert Storm to protect major oil producing facilities in the Middle East and a will to maintain the long-term credibility of economy policy that had been built up during the 1980’s.
To avoid being accused of inaction in the face of potential economic turbulence, the U.S. revised the Gramm-Rudman-Hollings Balanced Budget Act. Initially the act prohibited the U.S. from changing budget deficit targets even in the event of a negative shock to the economy. When oil prices rose, revision of this act allowed he U.S. government to adjust its budget for changes in the economy, further mitigating the risk of rising prices. The result was a peak in prices at $46 per barrel in mid-October, followed by a steady decline in prices until 1994.
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- Hamilton, J., Causes and consequences of the oil shock of 2007-2008, http://www.brookings.edu/economics/bpea/~/media/Files/Programs/ES/BPEA/2009_spring_bpea_papers/2009_spring_bpea_hamilton.pdf
- Roubini, N.; Setser, B. (2004), The effects of the recent oil price shock on the U.S. and global economy, http://pages.stern.nyu.edu/~nroubini/papers/OilShockRoubiniSetser.pdf
- Taylor, J., Discretion versus policy rules in practice, http://www.stanford.edu/~johntayl/Papers/Discretion.PDF
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