The Economy

Dec. 21, 2004
Don't oil prices matter any more?

A year ago, crude oil prices were at $10/bbl and falling. Now they are approaching $30/bbl and rising. In the past, a surge in oil prices always caused at least a brief downturn. The hikes in oil prices in 1973 and 1979 decimated the U.S. economy and were followed by the two longest recessions since World War II. Even the brief spike in oil prices in 1990 was accompanied by a recession, and while that decline was brief, the economy remained sluggish throughout 1991. But the recent surge has had no measurable impact on the economy. What happened to the impact of oil prices? It's true that the so-called energy coefficient, the amount of energy used per dollar of GDP, has fallen almost by half since the early 1970s. Even taking that into account, though, a $20/bbl increase in oil would seem to be no trivial matter. The U.S. economy uses about 19 million barrels of oil per day, or about 7 billion barrels per year. If prices rise $20/bbl, that is $140 billion extra that must be spent on oil, and presumably not spent on other goods and services. Even without any multiplier effects, that would reduce real growth by more than 1.5%. In addition, it would add 2.5% to the rate of inflation, pushing interest rates sharply higher and taking the starch out of the economy, to say nothing of the stock market. Maybe this still will happen, but I don't believe it and to the best of my knowledge, neither does anyone else. The most pessimistic forecasts still call for 3% growth this year. To a certain extent, the recent swing exaggerates the underlying change, because oil prices were averaging about $20/bbl before they dropped so sharply in 1998. Retail prices didn't fully reflect the drop then, and don't fully reflect the increase now. Also, many utilities have a great deal more flexibility and can more easily switch to natural gas when oil prices get out of hand. These differences are significant, but an even more important factor has been the complete lack of any ripple effect of higher oil prices on the overall inflation rate. Last year energy prices rose 13.4%, compared with an 8.8% decline in 1998. In the past, that 22.2% swing would have boosted the core rate of inflation, the rate excluding food and energy prices, by 1% to 2%, depending on underlying economic conditions. In 1999, however, the core rate rose only 1.9% -- down 0.5% from the 2.4% gain recorded in 1998. Thus to a large extent, higher energy prices were offset by lower prices of other goods and services. The same effect can be expected to occur early this year. Predicting oil prices has always been a tricky business. Before the slump in 1998, the Department of Energy (DOE) used to predict that in the long run benchmark crude oil prices would remain at $18/bbl in real terms; i.e., the nominal price would increase by the rate of inflation. After the 1998 decline, DOE lowered its estimate to $13/bbl, although the very-long-run graphs showed prices gradually recovering. In my view, the $30/bbl spike is the mirror image of the $10/bbl trough, and it won't last very long either. When prices fell to $10/bbl, OPEC got scared enough to put some real teeth in the production quotas, and we have seen the result. By the same token, once prices rise to $30/bbl, there will be an irresistible urge on the part of some OPEC nations to start cheating and increase their production. By summer I expect benchmark crude oil prices to be back to $20/bbl. Even in the very long run, I don't think oil prices will increase in real terms. Every time they do rise, alternative technologies are developed that reduce the energy coefficient further. Over the past 30 years, the single major cause of recessions has been oil shocks. Based on what has happened in the past few months, we can cross another reason for economic downturns off the list. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill. His e-mail address is [email protected].

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