What Should Central Banks Do IfOil Prices go to $100/barrel or more?

If oil prices were suddenly to skyrocket up to and over $100/barrel, what should the monetary authorities do about it?

On the one hand, if rising oil prices lead to an economic slow down, there would be pressure for the central bankers to inflate the money supply and hold down interest rates.

On the other hand, if real output were to shrink, inflating the money supply would cause serious inflation and have little impact on output, growth and unemployment.

I recall having talked with Tom Cooley many years ago about these questions. He recommended holding the line on money supply growth, possibly even reducing it, when the economy suffers negative output shocks.

That seems to be the long-run prescription from the Cleveland Fed:

Our experiments suggest that delaying further increases in the funds rate could help the economy through any potential “soft patch” caused by recent oil price hikes—without increasing the chance of inflation—but that the gains from such a change may be short-lived. Our anticipated-policy experiment demonstrates the downside of such a policy choice. The only reason that holding the funds rate constant substantially mitigated the output decline is that the public didn’t expect the Fed to do it. It might work once, but if the same response to oil price increases is given every time, it will eventually be anticipated by the public and do nothing to mitigate the output decline.

Nice how the effect of expectations is integrated into their analysis.

Thanks to Macroblog for the quote and link.