Gasoline prices have risen almost back to the highs seen last spring, although there's been remarkably little coverage. Such a move will affect the economy, whether or not it's noted in the headlines, especially if the higher prices stick. The experience last spring offers a model of what to expect. If the spike is short-lived, as it was then, the economy will show brief signs but quickly correct. If prices remain elevated for a period of months or rise farther, the pace of real economic growth, already anemic, will suffer. In time, the impact on general price levels could constrain the Federal Reserve's ability to consider further monetary ease.
The immediate picture is far from pretty. In the past few weeks alone, the national average retail price for a gallon of gasoline has risen almost 11%, from a low of $3.36 in late June to about $3.75. That is only 5.5% below the $3.94 high last April. In higher-tax states, such as Connecticut and California, the price per gallon has already topped $4, as it did last spring. Since the increase in retail prices so far has failed to keep up with the 20% rise in wholesale gasoline prices and the 27% jump in crude oil, chances are the price at the pump will move up still more in coming weeks.
Against this less-than-encouraging backdrop, there is reason to expect only short-term pain. Certainly the immediate pressures on gasoline prices would seem to be transitory. The storm in the Gulf of Mexico, Isaac, has disrupted production, but the effect will not likely last long. Damage from a fire at a San Francisco refinery that created a shortage on the West Coast will be repaired relatively soon. A pipeline rupture in Wisconsin that interrupted supplies flowing into the large Chicago market is already being rectified. In another temporary factor, refineries generally have slowed production as they anticipate cooler weather and retool from the distillation of gasoline to the distillation of heating oil.
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There is no hint of either fundamental supply shortages or demand excesses. Although the American Petroleum Institute reports a 15% drop in American crude inventories, ample new supplies are becoming available, in the United States with the new fracking technology, through new finds in the South Atlantic, and in the application of new technologies to existing fields. Saudi Arabia, for instance, is pumping more oil today than any time in the last 30 years. While supply picks up, the sluggish global economy has prompted the International Energy Agency to reduce its forecast of world oil demand in 2013 to 89.6 million barrels a day (mbd), from 89.9 this year. The American Petroleum Institute notes that demand in the U.S. in July averaged 18.1 mbd, down from 18.6 in July 2011 and the lowest level since 1995.
Still, two wild cards remain in this deck. One is the latest round of financial negotiations in Europe. If the Europeans fail to reach an accommodation with Greece, and talk of expulsion become something more than just talk, the consensus, anticipating crisis conditions, will downgrade growth forecasts for Europe and the world and, accordingly, for oil demand as well. Global crude futures would then retrace some of their recent rise and actual spot prices, would fall in tandem. But if, as is likely, Europe avoids this extreme, growth prospects, if still anemic, would improve at the margin, prompting oil prices to rise still more or, at the very least, hold their recent gains.
The second wild card is Iran. The tension related to Iran's nuclear ambitions has hung over the world oil supply outlook for some time now. It was such tension that prompted last spring's price spike, and a renewed concern about action in the Persian Gulf contributed to this most recent price rise. Should Israel strike Iran, as some suggest it will, even before the American elections this coming November, supplies from that important oil region would stop flowing, not just from Iran, which already has lost most of its markets, but also from Iraq, Kuwait, Bahrain, Qatar and the oil Emirates, all of which ship through the Persian Gulf. Even events far short of an Israeli strike could disrupt supplies. If a desperate Tehran, for instance, declares the Strait of Hormuz closed, the supply could stop as surely as if there were actual fighting. Even if Iran's navy could not enforce such an order, the threat could still shut down oil flows by prompting insurers to back away.
Though such geopolitical events cannot be forecast in any sense typically used in finance, they are nonetheless real. What is more, should such problems in the Persian Gulf, or even less dramatic events such as calm in Europe or a pickup in the pace of growth anywhere in the world, sustain or extend recent price increases, the effects on the U.S. economy are all too predictable.
Because the average American dedicates some 8% of his or her household budget to fuel, at least according to the Labor Department, if the recent gasoline price surge lasts for even a few more months, it could divert as much as $100 billion, or almost a full 1%, from consumer spending. The overall nominal retail and consumption spending numbers would stay up, since gasoline sales are a form of consumption. But the need to spend more at the pump would take from other sorts of purchases. Because other forms of consumption better serve to promote a general economic expansion and hiring than does spending on fuel, the effect on balance would slow the economy's overall pace of expansion and hiring as well. By itself, the strain could, all else equal, trim half a percentage point off the economy's overall real growth pace, not an insignificant amount with real gross domestic product growing at an annual rate of less than a 2% so far this year.
The strain would show in other ways as well. To the extent that households slowed their pace of saving to heat their homes and meet the needs of their gas tanks, the price hike would slow the pace of financial healing that has proceeded since this recovery began in 2009. Since households have a long way to go to reduce their debt overhang, any such interruption would delay still longer the time when the consumer could again offer the economy a robust growth engine.
Further, the inflation effects could eventually impact Fed policy. Initially, policy makers would ignore the general price effects of oil price hikes, noting, as they usually do, that their natural volatility makes them as likely to reduce inflation as add to it. But if energy price hikes stick, they would eventually filter through other costs into those "core" inflation measures to which Fed policy makers do pay attention. Given the slack in the U.S. and global economies, it is doubtful that the Fed would revise policy. But since some Fed board members and regional Fed bank presidents already have voiced concerns about the long-term inflationary consequences of the Fed's present, very easy monetary policy, such energy-based price pressures could, at the margin, dull the central bank's willingness to take yet another easing step.
The trend is far from sure. Indeed, it's still likely the recent oil and gasoline price run-up will reverse, as last spring's did. But there's clearly the possibility for something more substantive and long-lived, with all the attendant economic, financial and policy effects. Investors and business people need to prepare for the contingency, especially since some of the factors are fundamentally unpredictable.
For more recent analysis by Milton Ezrati, see Talk of Greek Expulsion Is Mostly Just Talk and Don't Get Carried Away by Housing Gains.
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