Monday, May 2, 2011

Do rising oil prices threaten growth?

Arab Light crude is about $25 shy of its 2008 all-time high (both in nominal and real terms), and it has been rising steadily since last September. As this chart shows, every recession since 1970 has been preceded by a sharp spike in real oil prices. Does the recent spike mean the economy is headed for another recession? I think there are good reasons why oil prices will not necessarily precipitate a recession. 

To begin with, the aggravating factor that precipitated every recession on this chart was a significant tightening of monetary policy, as characterized by a pronounced rise in real interest rates and a very flat or inverted yield curve, as illustrated in the above chart. Today the monetary situation is completely different; real yields are very low and even negative, and the yield curve is quite steeply sloped. Rising energy prices can be problematic when the Fed is tight, because tight money puts the economy on a strict monetary budget: when you pay more for energy you have to pay less for other things. Thus expensive energy can really squeeze the economy when money is tight, and it is the shortage of money that results in a recession. Today the Fed is quite accommodative, which means that the Fed is essentially working hard to ensure that expensive energy prices don't result in a shortage of money to spend on other things. 

The other reason is that our economy has become much less dependent on energy over the years, thanks to technological advances and conservation initiatives. Energy expenditures represented about 9% of all personal consumption expenditures in 1981, but today energy only consumes about 6%. Even though energy prices today are higher in real terms than they were in 1981, we are spending about one-third less of our incomes on energy today than we did back then. 

Update: To clarify my position on higher oil prices: they are a drag on growth because they make economic activity more expensive/less profitable on the margin, but at the same time higher oil prices put more money into the pockets of oil producers, who must then spend it on something else. Higher oil prices do not cause money to go down a black hole; dollars spent on oil produced by OPEC countries never leave the U.S., they simply change hands. Higher oil prices will slow growth, but at these levels they don't threaten a recession.

11 comments: said...

Yes, but not immediately. We are earlier in the business cycle than in 2008.

Benjamin Cole said...

I think commodities, save for the unpredictable gold and silver, have had the bulk of their movements. The high prices will bring out more supplies, and less consumption.

I think the oil thug nations are playing a dicey game--for them.

Every price spike means more consumers and businesses conserve, or turn to alternatives. And VC money is pouring by the billions into energy.

Some of the options already are remarkable, such as compressed natural gas (CNG) cars and trucks, and the Chevy Volt. (BTW, if the Volt had been built by socialist Swedes, the left wing would be crooning over it. But because stodgy old GM built it, no one seems to care. It is a remarkable feat of commercial engineering.)

Shale gas is a game changer. In many countries, CNG and LPG (liquified petroleum gas) cars are already common, such as Thailand. You can buy used CNG vehicles off the lot in Oklahoma at I have no connection to this website.

It is unfortunate that the US has gone the dead-end ethanol route, a farm subsidy program in drag. The rule is that all farm subsidy programs are immortal, as well as any agency within in the USDA.
Given the powerful rural-farm state colation behind ethanol, we may have a ways to go before we really let the free market beat the energy problem.

But eventually, the price system will bring us to a cleaner and more prosperous future.

Unknown said...

I am a financial consultant to small businesses. And I know a lot of little people. Both are reacting to higher gas prices as if it were a tax and are making up for it by spending less on other things.

I am not so sure of the protective characteristics of low interests rates, yield curves, and abundant money supply for the small businesses and little people. These folks are a drag on the economy.

There are two Americas.

Public Library said...

Fed actions are finding their way into the average citizens pocket via higher commodity and food prices.

Not cheaper financing rates. Mortgage rates have bottomed and credit card rates for AAA consumers such as myself are 13+%.

It's easy money for banks and big corp, not average Americans this time around.

Unknown said...

Scott, what do you think will be the effect of budget cutting?

I think it will contract the economy, no matter that it may be necessary.

TradingStrategyLetter - Weekly Summary said...

Mt friends are not worried about car payments ... they are more concerned with gas payments.

Scott Grannis said...

Re budget cutting: I've had quite a few posts on this subject, but the bottom line is that I think cutbacks in federal spending will be a stimulus for the economy. When the government spends less, the private sector has more to spend. The private sectors spends money more efficiently and effectively than the public sector. It's plain and simple logic.

Scott Grannis said...

Re higher energy prices and growth: I should clarify my views. Higher oil prices are a drag on growth but I don't think they will result in a recession. Higher oil prices result in a reduction in activity for many folks, but at the same time they put more money into the pockets of oil producers, who then have more money to spend.

TradingStrategyLetter - Weekly Summary said...

Scott U definately are a clear thinking Economist. Why the heck r u not in Washington calling the shots is beyond me?

Benjamin Cole said...

"dollars spent on oil produced by OPEC countries never leave the U.S., they simply change hands."

I think such dollars do leave the USA, and they create wealth and income in OPEC. Otherwise, why would they export?

TradingStrategyLetter - Weekly Summary said...

..,.to pay for all their wives and kids!