Thursday, April 15, 2004

Oil's Impact on the Economy
The latest Consumer Price Index (CPI) figures for the US indicated an increase for March of 0.5%, with core inflation excluding food and fuel of 0.4%. Even though the current high gasoline prices are not part of the core inflation rate, it looks like we are beginning to see the result of sustained high prices for the oil and natural gas inputs used by businesses in the goods they sell to consumers. Is this a real threat to the economic recovery?

The price of crude oil has been high for over a year, and natural gas has been well above its historical average since the end of 2002. This hasn't prevented the economy from growing so far, even though that growth hasn't generated many jobs, for a variety of reasons. In fact the Wall St. Journal's reporting of DuPont's recent announcement of 3,500 layoffs cited the high cost of natural gas as a contributing factor, since it is a major input in its basic chemicals business.

If the impact of higher energy prices is starting to show up in higher consumer prices for non-fuel goods, though, then this will influence policy decisions, such as the actions of the Fed's Open Market Committee, which sets interest rates. This week the stock market fell in anticipation of an increase in interest rates by the Fed next month. In effect, there is a delayed feedback loop by which high oil and gas prices increase inflation, which raises interest rates, which slows the economy.

None of this should be surprising. Crude oil and gasoline prices today are at about the level they were, in inflation-adjusted dollars, after the first Oil Shock in 1973-74. (See my posting of March 25 in archives.) The US economy is very different today than it was then, and the amount of energy required for each dollar of gross domestic product is lower. So barring a radical jump in oil prices from here, it's hard to imagine the same kind of economic malaise resulting from the current price levels. But that doesn't mean there's no impact.

Much will depend on how consumers will respond. If, for example, we were to change our driving habits, consolidating trips, carpooling, and shifting more travel to cars with better fuel economy, demand would start to moderate and that would ease prices fairly quickly. This would take some of the pressure off companies that produce goods for sale.

If, on the other hand, we ingore the gasoline price signal and continue the remarkable growth trend in miles traveled each year, and instead cut back our purchases of goods with a large energy component, then the economy will slow first, which will eventually result in lower fuel prices.

So even though it is natural to see the entire problem as being well beyond anything we can individually control, the reality is that the sum of all our actions as individuals will have a lot to do with how bad high energy prices end up being for the economy. So blame OPEC if it makes you feel better, but don't ignore what you are doing about it, yourself.

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