Why Higher Oil Prices Are Not a Threat to the Economy

Crude oil is in the spotlight these days, as its price climbs above $80/bbl. The trigger for higher prices appears to have been the news that gasoline inventories were much lower than expected. Surprise! Lower prices earlier this year combined with a rebounding economy added up to increased demand for gasoline. Is this a cause for concern? Hardly. Recoveries do not bring with them the immediate seeds of their own destruction. Prices are up because demand is up. The economy is stronger. If there is any cause for concern, it is that this is one more of many examples of why monetary policy is too easy these days, and why the Fed should be tightening.

These charts help put things in perspective. To begin with, in real terms oil is no more expensive today that it was in the early 1980s. It's actually much less expensive, when you consider that consumers spend about half as much of their disposable income on oil today as they did back then. The reason for that is conservation: our economy has become far more energy efficient. We use about half as much oil per unit of output today as we did back then. U.S. oil consumption today is about 19 mbd, which is the same as it was in 1980, and that's a rather remarkable fact since the economy has grown about 120% since then.

At the request of my friend Doug R, above is a chart showing real crude oil prices and recessions. He thought recessions were basically a direct result of a spike in oil prices, but wanted to see the evidence. Here it is.

My reading of this chart is this: recessions are often, but not always, associated with a spike in real oil prices. I think there is something else going on behind the scenes that is more important than oil prices, and that something is monetary policy.

Every recession on this chart was preceded to a significant degree by a tightening of monetary policy, and this observation taught me long ago that it is monetary policy that creates recessions. With one exception, every recession in the postwar period has been preceded first by easy money and then by a significant rise in inflation and a subsequent tightening of monetary policy. When inflation rises, it typically boosts the prices of raw materials, oil included. So the rise in real oil prices precedes some recessions is really just a symptom of rising inflation, which in turn is the result of easy monetary policy.

You can see this clearly in the next chart. Tight monetary policy invariably produces high real short-term interest rates (the blue line) and a very flat or inverted yield curve (shown here as a low or negative value of the red line). Easy money, on the other hand, pushes real borrowing costs to very low levels and results in a very steep curve (shown here as a high value of the red line).

The one interesting "exception" to my recessions-are-caused-by-tight-money rule was the recession of 2001, since it was preceded by tight money but not by rising inflation or exceptionally high oil prices. The Fed tightened policy in the late 1990s not because inflation was rising, but because they were afraid it might; this was a very unusual period in which the Fed was uncharacteristically preemptive in its policy actions. Sadly, although the tightening was probably not required, it still produced some painful consequences. The key factor triggering recessions remains, however: tight money. I would note also that while the 1990-91 recession saw a big but brief spike in oil prices, this was mainly due to the outbreak of the gulf war.

Since I don't think oil prices have yet risen by enough to result in any meaningful change in consumer behavior, and inflation hasn't yet risen by enough to trigger a big tightening in monetary policy, and the Fed is still very easy, I don't see any reason to fear a recession or double-dip recession.

Comments

[Dave Wrixon:]

For once I would have to agree with you, but only because you have got your cause and effect muddled up.

Crude prices are not going to cause a double dip recession. It is the fear of a double dip recession and the consequent meltdown of the dollar that is causing the the oil price spike.

Oct 22 09:22 AM

[User 353732:]

Big, bad, Govt =Falling Dollar

Falling Dollar = Rising Oil(and later iron ore, copper, natural gas, coal and food) prices
Falling Dollar = Capital flight + further net job losses
Falling Dollar = Rising consumer and small fear = further reluctance to spend and invest

Falling Dollar = Higher energy(and raw material)prices + capital flight + increased fear = Further economic compression in 2010

Oct 22 09:40 AM

[tripleblack:]

Interesting. I had never agreed that oil alone was the dominant force driving this cycle...

I wonder, does this onion have another, hidden layer?

If the recessions are usually triggered (if not "caused") by tightening monetary policy, what variables (economic, political, or whatever) are driving that tightening?

Oct 22 09:40 AM

[goldbug101:]

Inflation won't have any meaningful effect until net employment begins to rise.

Then lookout when everyone is back to work in the US - $200 bbl? $300?

When net employment starts to rebound it'll be USD crash unless Fed magically times their rate increase and it's significant (maybe 5% or more)

Oct 22 10:12 AM

[Sevens:]

While I agree with the logic that monetary policy has been the precursor to virtually every recession, ie, easy money building a bubble/tight money popping it, virtually since the Fed Reserve was founded, I can't agree that there's not much risk of a double dip recession.
Great book, that's a short read on this, is "The Origin of Financial Crises" by George Cooper.
My concern over a double dip recession isn't specific to just crude prices. It's simply that I can't put my finger on a single fundamental that tells me the economy is actually recovering, or that any recovery we've seen is based on solid fundamentals...however you want to slice it.
Dollar - weak
Interest - low, but govt is now paying higher interest on its record level borrowing
Retail - weak, probably weak holiday season
Housing - weak, with more waves of foreclosures to come
Energy - domestic drilling has virtually stopped due to prices & silly season in DC regarding cap & tax
More commercial debt defaults coming, more taxes coming, more entitlements coming, amnesty coming......
I'm not so worried about crude prices driving a double dip recession, but I'm darn sure worried a double dip recession is just a fundamental or two away from fruition.

Oct 22 10:31 AM

[Leftfield:]

I heard that line, oil prices don't matter as much, as they rose during this decade. Just like it was said in MSM, subprime foreclosures don't matter; they are a small part of a sector that, isn't that large anyway(!) You know, before the meltdown. I guess the idea was, Wall St, could push enough notations with enough zeros around and Washington could comply with their compromised GDP, BLS and inflation figures to keep the average citizen clueless and that would propel the economy.
I don't see the effects of a 120% increase in disposable income since 1980 the article alleges Americans to have; that can go with the second half of paragraph 1 above.
Are higher oil prices a green shoot?

Oct 22 10:45 AM

[Tony Petroski:]

The author:

"The economy is stronger. If there is any cause for concern, it is that this is one more of many examples of why monetary policy is too easy these days, and why the Fed should be tightening."

When does that happen? It will be interesting to watch.

The Beach pundit has been spot-on so far. It pays to pay attention to him.

Oct 22 10:59 AM

[ryanclarke:]

When someone in California ... who has a maid ... can't comprehend why the cleaning lady doesn't want to drive to their beach mansion because gasoline prices are $5 gallon ... even after doubling their wages to get the job done ... then maybe someone will understand the U.S. economy is based on a "cheap private transportation" model ... which is BROKEN ... because the cleaning lady and the grass mowing guy who both have to drive 50 miles one way to show up for work ... will realize their wages will have to be quadrupled to make it worth their DRIVE. According to the EIA gasoline demand in this country for 2009 is 9 million barrels per day ... exactly what is was in 2008 ... proving REGARDLESS of gasoline prices PEOPLE HAVE TO DRIVE A CAR TO GET ANYWHERE IN THIS COUNTRY ... until the price at the pump tells them it's not worth their time to show up to work.

Oct 22 11:06 AM

[chap08:]

User 353732, this is fantasy.

Yes, a falling dollar means higher oil costs, but that's just one part of the picture. As for "Falling Dollar = Capital flight + further net job losses", I'm sorry but that's just wrong.

The capital account clearly shows strong capital inflows over the last decade. What has that got us? Answer: too much capital and mal-investment in housing and treasuries. Meanwhile, China has had a capital account deficit. Did that result in a lack of investment in China? No. Poor Chinese businesses starved of investment funds? I think not.

We have no shortage of capital. We will still have plenty of capital even if we run a trade surplus. Even if were starting with little capital and then ran a deficit on the capital account, we'd still be fine - just ask China. We need to take a leaf out of China's book and play a smarter game. They held their currency down and have prospered. We allowed the opposite to happen and have suffered.


On Oct 22 09:40 AM User 353732 wrote:

> Big, bad, Govt =Falling Dollar
>
> Falling Dollar = Rising Oil(and later iron ore, copper, natural gas,
> coal and food) prices
> Falling Dollar = Capital flight + further net job losses
> Falling Dollar = Rising consumer and small fear = further reluctance
> to spend and invest
>
> Falling Dollar = Higher energy(and raw material)prices + capital
> flight + increased fear = Further economic compression in 2010

Oct 22 11:16 AM

[chap08:]

OK, so the US economy is based on an unsustainable model of cheap gasoline. Does that mean we should try and sustain the unsustainable model, or start doing something to change it? The longer we try and mask the real cost, the deeper in trouble we will be.

Note: in every other country on earth, the cleaning lady and the grass mowing guy take the bus / train / donkey / walk / whatever. When I have worked overseas, I have taken the bus / train / walk (OK, not the donkey). What is it about us that we think we deserve more?


On Oct 22 11:06 AM ryanclarke wrote:

> When someone in California ... who has a maid ... can't comprehend
> why the cleaning lady doesn't want to drive to their beach mansion
> because gasoline prices are $5 gallon ... even after doubling their
> wages to get the job done ... then maybe someone will understand
> the U.S. economy is based on a "cheap private transportation" model
> ... which is BROKEN ... because the cleaning lady and the grass mowing
> guy who both have to drive 50 miles one way to show up for work ...
> will realize their wages will have to be quadrupled to make it worth
> their DRIVE. According to the EIA gasoline demand in this country
> for 2009 is 9 million barrels per day ... exactly what is was in
> 2008 ... proving REGARDLESS of gasoline prices PEOPLE HAVE TO DRIVE
> A CAR TO GET ANYWHERE IN THIS COUNTRY ... until the price at the
> pump tells them it's not worth their time to show up to work.

Oct 22 11:26 AM

[Pink Panther:]

> this observation taught me long ago that it is monetary policy that creates recessions

Essentially, all that monetary policy does is following inflation, so it's not the fed who creates recessions but the market itself by demanding higher interest if inflation is beginning to set in. The fed merely has to follow, otherwise risking too much easy money for the banks (see recent history at the beginning of this decade)

Oct 22 12:31 PM

[JAMES CARLINI:]

NO, not a threat. More like a case of Swine flu which could lead to death of any recovery.

Oct 22 02:24 PM

[a fat panda:]

"To begin with, in real terms oil is no more expensive today that it was in the early 1980s"

I don't know about anyone else, but this is as close to the early 80s as I want to get.

FYI, the problem is the dollar. Oil is priced in dollars, and as it loses value the price of oil will go up. Keep in mind that today's price for oil doesn't reflect what the dollar is at today. It reflects where people think the dollar will be in the future. So as you cross $80 - or doubling in a year - you have to think that someone out there realizes just how screwed the dollar is.

Oct 22 04:14 PM

[Sevens:]

Amen and halleluia to all the "it's the dollar stupid" comments above! Heard a great comment recently, can't remember where, but everyone points to oil as the big culprit, because it's a published price that everyone can see on every corner gas station and as you fill your tank at least weekly. Why do so few look at the cost of literally every single other thing we buy in the same light (ok, besides the fact as well, that the fed/state govt's clip excise taxes, severance taxes, income taxes, prop taxes, etc on every drop of crude....)? How much did a decent new car cost in the 80's? I was in high school then and I can vividly remember when avg new cars sticker first passed about $10K....not uncommon for $30-$40K now. Clothes, groceries, guns, college, pick your poison..the answer's the same. Even though we're incredibly more efficient at producing a lot of these things, the prices of all staples have doubled at a minimum if not tripled or more.
But hey...high oil prices give the ignorant logic of cap & trade, paying alts like ethanol/solar/wind subsidies of all kinds to reduce demand in fossil fuels that PAY taxes, lousy monetary policy, etc....it's the old child's game of "look out for the airplane" (as you waive your fist in the air), get them to look at your fist, then kick'em in the shin as you say "gotta watch those submarines too!" We're getting kicked in the shins, still staring at the airplanes.

Oct 22 04:40 PM

[G. L. Turner:]

Hey Scott -
Tight Money - Well, when high gasoline/oil/energy SUCKS boatloads of money out of our economy, THERE IS LESS money - WELL, that sounds like 'tight money' to me...

Let me see, if I put 50 cents more per gallon in my car this week than last Monday, WHICH IS EXACTLY WHAT HAS JUST HAPPENED, DO I GET 20% MORE MILES PER GALLON than I did last Monday for the extra money I just spent...AND DO I HAVE the $20 left over (per car) x 2 avg. per household x 4.3 weeks = @$180 less PER MONTH to spend on things that have some real value and put other people to work ?

NO, I don't.

So, since a penny per gallon sucks out $1.47 BN per year from the economy, money that could be used to create more jobs, but now, due to the forces in control, it actually goes into the hands of Gov Sachs, JPM , MS and the hedge funds you counsel...and then on overseas to foreign oil producers...well, I do not see any intrinsic economic value to me and my buds from this ridiculous speculation that has caused these pricing aberrations, not in sync with s/d fundamentals.

That 'the gasoline inventories last week reflected higher demand' - BS!

The oil companies cut back refining capacity significantly a couple of weeks ago as the price was drifting downward to $1.65 RBOB, as it should have been. BUT, Exxon did not like this and they called up Blankfein and says, Hey Bud, how about you guys jack up the markets again as we need to make more money...course, once this occurs, it has far reaching effects suppressing OUR ECONOMY as it sends dollars to a few already swollen Wall Street Pockets and a number of them 'over the pond'.

Things are greatly exaggerated now than before as per the huge amounts of monies now playing carelessly in the futures markets. The swings, and consequences of such, are much more harsh and severe now.

Oil right now today, should be @$69 - 70 based on the dollar and REAL S/D - RBOB should be $1.65-$1.70.

Remember last year's testimonies by Big Oils' CEOs..."we just need $65 per barrel for oil to make a good profit...which translates into $1.65 RBOB and retail from $2.00 to $2.50 depending on state. When the top taxed states hit $2.50 the week before last, that was it...things had to go back up and fast...and voila', they did...and Gov Sachs hath commanded that we MUST see $85 Oil this quarter...SO BE IT!, RIGHT?

The whole thing is a scam, now..controlled by a few greedy financial firms, adding NO VALUE to the natural Flow of Energy TRADING, but rather causing much pain globally. The basic economy needs cheap energy to recover and grow, especially since there is no manufacturing engine in the USA to really drive our growth. Our move to better fuel efficiencies will have to made by mandate - for the 'free market' will result in more wealth for Gov Sachs and ilk, and no future for the maid, the gardener and about 80% of the rest of AMERICANS. When we spent more for energy this simply translates into "more money SPENT for energy'...not more mileage, more goods or services purchased and obtained ! It actually means LESS!

Kudlow, in April 2008, when Oil had shot on past $100, said "it would not hurt the economy" - I scolded him - but within 75 days everything crashed - but he and the WS boys and Bush said we should blame it on housing and sub-prime...

Did anyone add up the losses on commodities in 3rd Q of all those WS firms we bailed out? NO, they only talked about the losses from credit deriatives and mortgages...(of the losses, there was about 30% due to commodity trading...)

(Guess that covers it and most of the comments, too!)
Good Day.

Oct 22 10:34 PM

[Plan B Econ...:]

There is a limit to which the global economy can tolerate oil prices. Oil is a factor of production. Increase the cost of factors of production and profit margins get squeezed or prices rise. Either you end up with less production or less consumption - both cause a decline in GDP growth.

People are warning of another oil crisis within a few years. It's not just the 'fringes' anymore...oil executives, supranational bodies, etc.

www.planbeconomics.com.../

Oct 23 01:02 PM

[jerrydd:]

The author and most here are smoking good stuff I see.

The price of oil is in everything!! When it goes up so does everything else including inflation, No? Then the money supply gets tighter as the gov fights inflation.

As for Bush 07 stimulus it failed for 1 reason, the rising price of gas ate it up and more.

And next yr as the price of oil hit $4-5/gal again you can expect the economy to dive because it will eat what little most people have.

So keep thinking oil doesn't matter and lose your shirt again..

Oct 23 01:19 PM