The illusion of inventory and price controls

Systemic disruptions of supply chains over the past two years because of the pandemic and, more recently, the Russian invasion of Ukraine have renewed calls for political authorities to do something about soaring prices.

With inflation hitting 8.5% in March and risks of another oil and energy price shock should the war deteriorate, the impulse of policymakers to take more action is rising. As one might expect, this has resulted in talk around price controls should conditions in commodity and energy markets deteriorate further.

The exigent circumstances under which the federal government needs to step in and put on what might be termed as “hard price controls”—as opposed to “soft price controls” of the type that are regular features of the American political economy—are simply not present despite the war in Ukraine.

The immediate instinct to do something to provide relief to households under duress because of rising inflation and the jump in gasoline prices is indeed understandable.
After all, fuel oil prices accounted for about a quarter of the 6.8% inflation rate encountered by consumers last year, and now, most recently, more than half the 1.2% monthly increase in the consumer price index in March.

But the imposition of price controls, in our estimation, would be a significant policy mistake under current economic conditions.

What are price controls?

Price controls are easy to talk about but are far more difficult to understand, given the government’s participation in setting basic prices like interest rates and in health care across the American economy.

First and foremost, let us dispense with the gentle fiction that we Americans like to tell ourselves. There is no such thing as a perfect market, and in many of our most important markets, price is not purely a function of free exchange.

Rather, prices are the result of a complex and deep set of interactions that involve regulatory activity and direct government intervention.

That being said, many forms of price controls—such as rent controls—are generally and widely recognized as mid-20th century failures that distorted market functions, resulting in pervasive shortages and increased costs. That should not be replicated anytime soon.

The ideas of price controls need to be defined first before moving on to a general evaluation of them under current conditions.

Price controls should be best understood as the range of costs influenced by various degrees of government intervention into markets.

They can be viewed as existing on a spectrum that moves from left to right, with those on the far left-hand side reflecting little to no government influence on prices and those on the far right-hand side reflecting a hard cap on the maximum that can be charged for a good or service.

So what does that look like? The minimum area of price control, and the most subtle, is the permanent intervention by the Federal Reserve into financial markets through its daily open-market operations. The operations desk at the Federal Reserve Bank of New York controls moves in the federal funds rate. It remains the primary policy tool of the Federal Reserve in determining the price of money for fixed-income securities from overnight rates out to 30 years’ maturity.

So the common assumption that the price of money along the maturity spectrum is set by the private sector is a gentle untruth. Interest rates are significantly influenced by the policy preferences of the central bank. We would assign a score of 1 to this subtle form of price control on our sliding scale, putting it at the far left of the price control spectrum.

In the middle of a spectrum, one might think about the cost of medical care. Health care, in general, accounts for roughly 18% of the American economy. For roughly the past century, the federal government has participated in managed care and, in some cases, set the price of medical care and drugs.

The current policy debate around setting a cap on the cost of insulin is a prime example of the long-term capping of prices on medical care. In our estimation, this would be assigned a score of 5, sitting midway between no control and total government control.

On the far right of the spectrum would probably be what most people would define as price controls when the government directly sets the cost of a good or service with little or no market participation in the setting of such costs.

The best example of this would be what the United States did during World War II through the Roosevelt-era Office of Price Administration. The OPA set prices in just about every market imaginable to support wartime efforts to run the economy at maximum output and to support wartime production under conditions of general resource constraints. If one wanted to purchase gasoline, rubber, sugar or coffee during the war, one had to do so under conditions of general rationing.

The only period of the modern era that resembled this was during the Great Inflation era of 1965 to 1985, when people in some states could purchase gasoline only on days that matched the last number of their license plates.

Short-run disruptions to the global oil and gasoline markets resulted in states like California, New Jersey, New York, Pennsylvania and Texas all rationing gasoline. In California in 1979, residents with license plates that ended in odd numbers could obtain gasoline on certain days and those with even numbers on others.

If hard price controls like those imposed during the war earned a 10 on our spectrum, the gasoline rationing imposed during 1979 would garner a 7. The Nixon-era wage and price controls would be a 10, right up there with Roosevelt’s OPA era.

1979 redux?

Rising energy prices are stimulating calls for the U.S. government to do something in response to the Putin price shock that caused the cost of gasoline in the March CPI to increase by 18.3%. Tapping the strategic petroleum reserves, selling more leases to drill on public land or in the ocean, and imposing price controls have all become part of that discussion.

After the failure of ill-conceived price controls in the 1970s, the standard reaction to price spikes has been to demand intervention in the supply of petroleum products. The thinking is that any steps toward increasing supply would be met by increased production by foreign (and now domestic) producers that are more concerned with maintaining market share than profit.

In order to proceed in this conversation, it is important to note the current conditions within such policy decisions need to be made:

• North America is energy-independent for all practical purposes.
• Inflation and, in particular, energy-price inflation have reached 1974 and 1980 levels.
• The war in Ukraine will inevitably lead to lower fossil fuel supplies. Russia is second only to Saudi Arabia in production. The war seems likely to lead to higher petroleum prices, disruptions to the global supply chain and an economic slowdown spilling over into most if not all economies.
• Private financing has become more difficult for the fossil fuel industry. Lenders are unwilling to risk volatile pricing in a resource extraction business with a shrinking investment horizon and whose significant competitors are state-run enterprises that have shown their willingness to exert their dominant position.
• The developed economies are quickly turning to renewable energy. At some point, that will severely crimp the demand for fossil fuels.
• The price of petroleum is determined within a global marketplace that consists of producers, consumers and speculators. Each of these is concerned primarily with its own self-interest.

State actors are becoming involved. Lithuania has ceased all purchases of Russian energy, even though it is the cheapest source available. Germany is reluctant to endure the economic damages if it were to cut off Russia’s supply of natural gas and coal. Yet given the war’s direction in Eastern Europe, that may become a short-term reality.

And the European Commission is now requiring EU countries to fill their natural gas storage to at least 90% of capacity ahead of winter. The Biden administration has coordinated the release of oil reserves among
allied countries.

Lost economic output from the two oil shocks in the 1970s was estimated at $1.2 trillion in 1997-98 dollars by the U.S. Department of Energy. There will undoubtedly be economic losses in this current episode, but will these well-intentioned steps mitigate those costs? Let’s look at the track record of market interference.

Past instances of price controls

Market intervention in the U.S. economy would not be new. As we mentioned, wartime wage and price controls remained in place between 1942 and 1946.

Following the lifting of wartime price controls, inflation moved sharply higher through the end of 1948 and then eased. Nevertheless, it took the rest of the decade and beyond to retool for a peacetime economy and resolve supply and demand imbalances. (This will likely be the experience for Europe as it makes the transition away from Russian energy supplies and fossil fuels in general.)

In 1970, the Nixon administration implemented wage controls in an attempt to control inflation. Between 1974 and 1977, the Federal Energy Administration implemented oil allocation and pricing regulations in response to the first Arab oil embargo.

But those price controls didn’t work—the price of gasoline continued to rise, and price controls and stringent rules for purchases resulted in inefficiencies. In short, the Nixon-era price controls spectacularly failed.

Instead of mandating a single price level, prices were allowed to increase in increments based on the previous day’s price. So, of course, rational providers held back supplies until the following day when prices were higher. And consumers took to driving miles to find gasoline when their local gas station ran out or using two sets of license plates to avoid every-other-day restrictions.

In our estimation, the oil shock of the 1970s created the conditions for the worst of the Great Inflation era that did not ease materially until reaching nearly 15% in 1980. It took the monetary-policy shock of Paul Volcker, the Fed chairperson at the time, and the severity of double-dip recessions that followed to end inflation’s grip on the economy.

The benefit of the 1970s price shocks was a change in consumer taste that tempered the wasteful use of fossil fuels. We do not think that is what it will take to address the current policy challenge around inflation.

In the decades after the 1980s and until the pandemic, several factors expunged excessive inflation from the economy. These included the demise of union power, the shift of the production floor to low-wage production centers, and the ability of the global supply chain to deliver cheaply made goods to consumers and manufacturers.

More recently, technological advances have allowed for profitable extraction of North American crude oil, which has allowed for the supply side of energy independence.
But crude oil is a fungible commodity, the price of which remains arbitraged within a global marketplace, with the majority of supply determined by state actors not aligned with Western ideals.

Short of further devolution of this crisis, we do not see any material changes that would require the implementation of price controls. The Fed has the tools to deal with inflation, and with the exception of exigent circumstances, it’s best to have consumers determine how much petroleum they need to consume.

Inventory control

In a 2001 paper, “The role of inventories in oil market stability,” the economists Amy Myers Jaffe and Ronald Soligo argue that in the case of energy commodities, “it is reasonable to ask whether the management of inventories can be left to market forces. After all, petroleum products are a vital input to the economy and national security purposes.”

During the time of the paper’s release, substitutes for fossil fuels were not easily available for private transportation, while switching among home heating alternatives remains costly for most households to this day.

As the authors put it, the issue is whether private agents will hold the socially optimal level of inventories to meet the “once-in-a-decade” supply shocks that characterized the 1970 Arab oil embargoes. We now need to add the shocks of the supply-demand imbalances of the pandemic era and the removal of Russia’s supplies from the world market.

Maintaining large inventories can be costly, and we cannot expect private agents to do so profitably. Should the government have a role in stabilizing the availability of essential goods such as energy or food?

The authors found that commodity markets are unlikely to provide socially optimal inventories if left to their own devices. And though buffer stock programs became fashionable in the 1960s and 1970s and were initiated in sugar, tin, cocoa and natural rubber markets, the authors point to the consensus that the programs were not working and that serious consideration of such programs has ceased.

We find that the inverse relationship between private inventories of crude oil and its price has grown stronger, with a correlation of negative 0.85 over the past 10 years. This implies that as the benchmark price of the West Texas Intermediate crude oil declines, the amount of oil in storage tends to increase. Conversely, as the price of WTI rises, the amount of storage drops.

Correlation does not imply causality, however, but rather co-movement. As such, our analysis suggests that when prices move higher, inventories are drawn down, perhaps because production does not or cannot keep up with demand.

In this latest period, there is a reluctance to finance additional oil production for concern over price volatility and loss of previous episodes and because of the limitations of the investment horizon as Western nations move away from fossil fuels.

Finally, the jury is still out on whether the recent drawdown of the Strategic Petroleum Reserve will help at the margins or will be countered by OPEC policy and expectations of further conflict.

Patience

The experience of the dramatic drop in demand for oil during the pandemic—which was quickly followed by an inadequate production response to the post-pandemic surge in demand—should put to rest the idea that price signals alone are infallible.

Meeting an upsurge in demand or countering the loss of Russian supplies is not just a matter of flipping a switch in the Permian Basin.

Nevertheless, there are costs of ignoring price shocks in essential commodities. If this latest episode of higher prices continued, there would certainly be a misallocation of resources and economic losses. However, those losses would not be equally distributed among households or businesses.

Academic work appears to be somewhat inconclusive regarding an asymmetric relationship between energy prices and output. While higher energy prices can result in lower gross domestic product, lower prices are not necessarily a cause for higher levels of GDP. But that might depend more on the time frame and technological changes.

Should the government intervene in every instance of market failure? Was the government obligated to step in on behalf of oil producers when the market plunged during the pandemic?

The current market is unlike any previous episode of volatile petroleum pricing. Instead of dealing merely with OPEC, Europe is dealing with an expanded OPEC+ that includes a nation armed with nuclear warheads.

This current pricing episode started with the price of West Texas Intermediate crude oil peaking along with the economic recovery in June 2018 at $74 per barrel. Price then began dropping as the U.S. trade war became the 2018-20 global manufacturing recession.

WTI futures prices had already dropped to $45 per barrel by February 2020 before plummeting to below $20 by April as the pandemic shut down the economy. Inventories became so bloated that the futures price became negative, with nowhere to store the excess oil.

Twelve months later, the price increased by a record 237% to more than $63 per barrel from a low starting point of $18.84 as the economy reopened and demand surged.

Then in early March, Russia’s invasion of Ukraine pushed WTI prices as high as $123 per barrel. Prices fell to $94.29 by the second week of April, essentially an increase of 62% from last April, with the markets unsettled as they wait for the next shoe to drop.

Price increases do not last forever. Our analysis shows that since 1986, in five of the nine episodes when the WTI price increased by 50% or more relative to the previous year, prices troughed three to five months after the peak month. In the remaining four episodes, it took from nine to 19 months for prices to subside to levels before the spike.

So if it weren’t for the events in Ukraine, there would be a case for patience. Last year, the spike in oil appeared to be resolvable 12 months after its beginning. But a second spike occurred because of the increased risk of the war spreading beyond Ukraine.

Consumers have shown the ability to adjust spending habits and lifestyles to the new level of prices at the pump. Because of the war, they now have to alter their expectations of maintaining whatever lifestyle they might have already adopted.

The takeaway

There are two lessons from the 1940s and 1970s. First, while there is a rationale for price controls during wartime—when the entire country is enlisted in self-preservation—the 1970s episode was not an example of that. The embargo didn’t last forever, and we all got through it, albeit in compact cars. Second, prices in an open economy are the most efficient mechanism for determining consumer choice.

The current episode of extremely high oil prices cannot necessarily be categorized as a market failure. Instead, prices are high because of geopolitical uncertainty and the failure to move quickly beyond a single energy source.
Rather than manipulating the supply or demand for oil, governments might find it more efficient to advance the transition from fossil fuels and subsidize those who cannot afford to make that transition quickly.