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

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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.

In post-World War II recessions, the Fed had either been tightening monetary policy (raising interest rates) prior to the onset of the recession or did so immediately after the spike in oil prices. Rising inflation-adjusted interest rates provided an additional channel through which the oil shock was transmitted to the real economy (the part of the economy producing goods and services). For example, the real fed funds rate hit 4.5 percent in 1973 and 9.3 percent in 1981. With a weak recovery after the Great Recession, and slack in labor and product markets, the Fed simply won't engage in such a highly restrictive monetary policy stance. Today, the Fed would likely move to implement a third round of quantitative easing in reaction to a spike in prices in an effort to boost the economy. Today's range of oil prices are not high enough to trigger a recession.

To gauge the impact of the recent rise in oil prices, I used a dynamic macroeconomic model of the U.S. economy. By raising oil prices from $95 to $105 in the simulation, we gain an estimate of the broader impacts on the U.S. economy. The results show a relatively small impact. A $10 oil price increase, sustained over four quarters, decreases real GDP growth by 0.2 percentage point. The impact on consumption spending is twice as large: 0.4 percent. Investment growth falls by just 0.2 percent as IT equipment and software aren't as sensitive to rising oil prices. Higher oil prices would reduce growth in non-oil-producing developing countries such as China and India, cutting U.S. export growth by 0.3 percent. The impact on exports isn't as large as you might anticipate, since large oil-producing countries (especially Canada and Mexico) eventually import more from the U.S. These impacts are shown in the table below.

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HAVE THE RULES CHANGED?

Some observers suggest that there may be an important psychological trigger point at $100 per barrel level, where consumer confidence falls further than the incremental $10 increase in price might precipitate, resulting in postponement in discretionary purchases based on fears that prices could go even higher. A standard macroeconomic model may not capture that response. There's some evidence that this happened in 2008, but it's difficult to discern with any statistical precision. However, there is some statistical evidence demonstrating that consumer confidence is harmed when the price of gasoline crosses a dollar threshold; for example, moving from $3.55 to $4.05 per gallon. This might push the impact of an incremental $10 increase in oil prices to 0.3 percent off of real GDP growth if that threshold price is passed. Another $5-7 increase in oil prices would move the national average gasoline price above $4.00 a gallon.

Based upon the structure of today's U.S. economy, an increase in WTI to $150 per barrel and $170 for Brent are necessary before the probability of a U.S. recession reaches 50 percent. However, rising oil prices, in combination with other adverse developments such as further deterioration in Eurozone economies or a harder landing in BRIC nations, leave the U.S. vulnerable to weaker growth or outright recession. If U.S. real GDP growth dips to 1.0 percent, job growth could stagnate.

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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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