Right now the greatest threat to America's economic recovery and to further market gains is the situation in the Persian Gulf. Absent this danger of higher crude and gasoline prices, investors can reasonably anticipate a durable, if plodding, economic recovery and modest relief from European debt fears now that the European Central Bank has adopted an easier monetary policy. It is, then, the potential economic fallout from higher oil prices, not to mention the shock of a military confrontation, that poses the biggest risk. If probabilities still favor some easing of tensions and so continued economic and market gains, the danger is significant enough to warrant serious attention.

It understates the current situation in the Persian Gulf—grossly so—to describe it as tense. Whatever quibbles emerge among the different intelligence sources, the basic contours are clear enough: Iran is on the verge of getting a nuclear weapon. It has already demonstrated rocket technology capable of delivering that weapon, by some estimates, as far as the United States but certainly as far as Europe and, of course, Israel. Tehran has stonewalled all efforts by the United States, the United Nations and the international community more loosely defined to discover where its program stands or what its intentions are. A sanctions regime, cobbled together by the United States and major European nations, seems to have hurt Iran, despite opposition from Russia and China. No doubt that pain has prompted the government in Tehran to invite renewed negotiations, though Iran's past behavior leaves little reason to expect success. Military action from the United States, Israel, both of them or even, peremptorily, from Iran, remains a real threat.

Even now, well short of those extremes, the current level of tension and the threat it constitutes to ongoing oil flows have pushed up petroleum prices significantly. Since last fall, when the latest problems with Iran began to mount, the price of a barrel of oil (West Texas Intermediate) has risen more than 40%, from about $78 to about $110. The price of gasoline has risen almost as much, by 30%, from a national before-tax average of $2.40 a gallon to $3.12. Since according to the Labor Department, fuel of all kinds constitutes about 9.8% of the average American's budget, this oil price rise has already siphoned more than $280 billion, or about 2.5%, from households' other consumption options. That more than eats up, as the media widely indicated, the value of the payroll tax-cut extension Congress just recently passed and the President signed.

And these recent strains pale next to what could happen should tensions in the Gulf intensify. Even something far short of an outright military exchange could raise oil prices toward their 2008 highs of over $140 a barrel. Iran need only threaten to close theStrait of Hormuz, and tanker traffic would stop. Regardless of assurances by the U.S. Navy, insurers would forbid its use, even if shippers and oil companies were willing to take the risk, which they surely would not be. The oil price could stay at that high, too, for as long as such a threat remained in place. If actual shooting were to start, few suggest that the operation would run its course quickly, as attacks would lead to retaliations and then retaliations to the retaliations. In such an environment, still more extreme and lasting oil price hikes would become a significant possibility after the first exchange of fire.

An increase to the 2008 highs would constitute an additional 30% rise in the price of crude, which, especially if it persists, would bring wholesale, that is before tax, gasoline prices to over $4.25 a gallon. With taxes, the price at the pump could exceed $5 in some parts of the country. Such a jump would redirect another $440 billion from other household spending, enough to erase almost an entire year's consumption growth, if it lasted long enough. Open hostilities could, of course, raise prices even farther, almost assuredly stalling the U.S. economic recovery or creating outright recession, again if they were to last long enough.

With the situation highly unstable, all of this, of course, remains conjecture. The hope—the expectation—is that the powers involved can reach a resolution without resorting to military action or even a standoff that prompts insurers to close down shipping. After all, for all the tension to date, oil flows have continued uninterrupted. Should such a resolution develop, crude oil and gasoline prices would certainly drop from today's highs. Though they would not likely recapture the lows of late last year, a wholesale gasoline price of $2.50 a gallon is plausible, or $3.30 to $3.50 at retail in high-tax regions. Even if today's level of tension were to sustain current prices indefinitely, it would cause little more harm than it already has. But until some resolution is reached, risks for much higher prices remain significant. Whatever the present probabilities, the instabilities demand that investors stay on their guard and that they make plans for portfolio adjustments, should matters deteriorate.

Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. See more of his articles about the economy here.

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Ezrati&rsquo;s Economic Outlook: Oil Prices Pose Biggest Threat

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