The $110 Effect: What Higher Gas Prices Could Really Do to the Economy

The relationship between high gas prices, consumer spending, business investment and Federal Reserve policy is more complicated than most people give it credit for

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Reuters

Rising oil and gasoline prices are once again threatening the U.S. economic recovery. It is no surprise that the root cause is geopolitical turmoil in the Middle East - this time related to Iran's nuclear ambitions and potential disruptions in oil supply

At this point, it is the threat of Iranian oil supplies being removed from the market that is pushing prices higher. Saber rattling by Iran is contributing to the speculative price spike, perhaps a key strategy to maximize its oil revenue even with weaker volumes. West Texas Intermediate (WTI, the leading benchmark in U.S. oil pricing) passed the $100 threshold and crossed $110 per barrel briefly. Brent crude, the other pricing marker, surpassed $120 per barrel.

Rising oil prices will harm U.S. economic growth. But what is the likely magnitude? Higher oil prices have played a role in U.S. recessions since 1973. But correlation doesn't necessarily translate into causation. Causation depends on a number of factors and transmission through the economy and, most importantly, whether the Federal Reserve tightens monetary policy in respond to higher oil prices. Furthermore, the impact is conditional on expectations of whether the price increase is transitory or longer lasting.

Consumers. As higher oil prices manifest themselves in downstream prices of gasoline, diesel and other refined petroleum products, they force consumers to shift discretionary spending away from big-ticket purchases of autos, furniture and appliances. Higher oil prices also crimp consumer purchases of nondurables--if you're paying more at the pump, you've got less to spend on shoes, dining out and going to the movies. In many respects, higher oil prices act as a tax on consumers, and most of those dollars move out of the United States.

Consumer demand for gasoline is the biggest end-use category. American consumers purchased 172.2 billion gallons of gasoline in 2011, spending just over $400 billion, excluding federal and state taxes. Each 50 cent increase in the price of gasoline adds almost $60 billion to annual consumer bills, roughly the spike over the past few weeks. In the short-term, the price elasticity of demand for gasoline is fairly inelastic (not sensitive). The most immediate response is for consumers to alter their behavior. Households reduce their leisure driving and use more public transportation. Additionally, consumers shift more transportation fuel purchases to alternatives such as a higher blend of ethanol.

Consumers have adjusted their spending patterns on gasoline since the 2007 spike in prices. On a per capita basis, consumer demand has fallen from 610 gallons in 2006 to about 550 at the end of 2011 (see chart), a reduction of almost 10 percent. Overall, consumption of gasoline is down by nearly 7 percent over the same period.

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Businesses. Escalating oil prices also feed into the economy through higher input costs for energy-intensive firms. Supply chains spread the cost throughout the economy as businesses that consume lots of oil attempt to raise their prices in an effort to maintain profit margins. For example, higher oil prices increase the production cost of fertilizers and food processing and are passed on to consumers as higher prices at the grocery store. As these cost increases ripple across multiple supply chains, they can push core inflation higher - if the oil price increase is sustained.

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It is not only good short-term news that consumers have cut their purchases of gasoline since the 2007 jump in prices; it's even better long-term news for the broader economy. As the chart above shows, the U.S. economy doesn't require as much oil to produce a given level of GDP as it did prior to the first oil price shock (OPEC I) in 1973-74. Oil consumption (average barrels per day) per $1 million of real GDP dropped from 3.34 in 1975 to 1.46 in 2010, a 56.2 percent drop. A confluence of factors contributed to this, ranging from the introduction of more energy-efficient capital equipment and transportation vehicles to natural gas replacing oil in electricity generation. Oil accounts for miniscule share of electricity generation (less than 1 percent), the biggest reduction of any end-use segment since OPEC I.

Presented by

Ross DeVol is chief research officer at the Milken Institute, a non-partisan, independent economic think tank. He is also author of “Jobs for America: Investments and Policies for Economic Growth and Competitiveness.”

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