Will Oil Prices Kill the Recovery?

In the past six months, gas prices have climbed more than 70 cents, but in the past two weeks alone, they're up 34 cents. As the cost of gasoline rises, more money is drained from the pockets businesses and consumers. That cash could be compensating new hires, buying retail products, or even paying down debt. There are a number of different ways in which increasing oil prices endanger the U.S. recovery, but at what point will we really see the economy begin feel a shock?

The Constant Threat

There are a few ways to look at this question. One is to consider rising oil prices in a straightforward manner: the moment gasoline prices begin to rise, consumers and businesses will have less money to spend on other things. So in that sense, the economy has already begun to endure this change. While it's possible for some Americans to cut back a portion of leisure driving in response to higher gas prices, the millions of Americans who drive each day to work will see their commuting cost rise. And for those who do cut back on non-essential driving, their trips to shops, malls, and restaurants will decline, which will also indirectly impact overall spending.

But how do we know higher expensive fuel costs are really being felt? At some point, rising gas prices will begin to translate into fewer retail sales due to a greater portion of disposable income needed for driving. As the recovery has grown stronger, we've seen new highs in retail sales. If we begin to see those numbers tick down over the next few months, then that will almost certainly be due mostly to the oil shock.

When do we have to really worry? Little reductions in spending won't kill the recovery: they'll just slow it down. At what point will Americans feel so pinched by high gas prices that they will cut spending drastically and the economy will take a significant step back? There's no clear answer, but you can look at it from both qualitative and quantitative perspectives.

When Expectations Change

From a qualitative perspective, gas prices become a real problem when expectations change. Oil has become more expensive for two reasons over the past few years. The first has simply been the recovery itself. As people spend more money globally, their demand for gasoline rises, which boosts prices. The second has been the unrest in the Middle East. Fears that the recent political instability could cut supply from the region have sparked speculation that has pushed up prices.

This latter cause has been the reason for the steep climb in oil recently. Check out this chart from the Energy Information Administration on gas prices:

gas prices 2011-03.gif

Since the economy bottomed in late 2008, oil prices began rising. Since late January, however, you can see that their climb steepened. This coincides with the Middle East turmoil. So the recent big jump is tied to that shock. If Americans believe this unrest will soon fade away, then their expectation will be that oil prices will drop in the months to come but then continue on their course of steadily rising due to the recovery. If this is the case, then a double dip isn't as likely.

Unfortunately, expectations appear to indicate a view of the steep increase in prices continuing. A recent poll by Rasmussen indicates that 58% of Americans find it at least somewhat likely that gasoline will hit $5 per gallon by July 1st. That could be catastrophic, as it would mean gas prices would have doubled in a year's time. Expectations are very important, because they affect reality even if they are ultimately incorrect. If most Americans believe gas prices are permanently rising aggressively, then they may begin, or have already have begun, cutting their spending accordingly.

Fear $150 per Barrel Oil

Then, there's the quantitative aspect. How high do oil prices have to rise to threaten the recovery? Unfortunately, there's no clear answer, as different economists have different views on the effect of oil prices. One estimate by Ross DeVol, executive director at the Milken Institute, indicates that for each $10 per barrel increase in oil prices, real GDP growth will decline by 0.2%. Goldman Sachs economists have a similar view of oil's effect on GDP -- that a 10% sustained increase in the price of oil will reduce U.S. growth by 0.2% this year and by 0.4% next year.

But when will rising prices create a double dip recession? DeVol says that WTI crude would have to hit $150 per barrel and Brent must reach $170 per barrel before another U.S. recession seems plausible. Currently, prices for those two measures are about $105 and $116, respectively. So the good news is that they have a ways to go before reaching that point.

Rising oil prices pose a serious threat to the U.S. economy. As Americans begin to worry that higher prices at the pump are permanent and will continue to rise, their spending on other goods and services will decline. For now, however, it would be premature to forecast a double dip. But if prices continue climbing at the rate they have been over the past few months, then usual seasonal gas price increases in the summer could drive them to a dangerous level for the U.S. recovery.