Over the 12 months ending in January 2010, the price of oil doubled. This record price increase was not much remarked upon because it reflected normalization in the economy and commodity prices. Over the 12 months ending in the last week of February, the price of oil increased by one-third as much, but because the growth was from $75 per barrel to $105, the price increase has been unwelcome and attention-grabbing.
For the U.S., the oil price increase is not just politically unwelcome, but also economically problematic. Higher oil prices impair the U.S. in terms of trade and add to the current account deficit. Left unchecked, higher oil prices have the potential to lead to another U.S. recession, as the implicit tax of oil reduces purchasing power and makes some U.S. goods uncompetitive.
The first problem posed by higher oil prices is the impact on consumer budgets. The U.S. is especially exposed to oil price increases because oil accounts for 94% of the energy Americans use for transportation.
One way to capture the impact of oil price increases on household budgets is to compare wage rates to per-barrel oil prices. Average hourly earnings of private sector workers are $22.87. This means that the typical worker has to log 4.5 hours at work to buy a $105 barrel of oil.
The chart below compares this relationship over time. When the economy was growing rapidly from March 2006 until August 2007, it took less than three hours of work, on average, for the typical worker to buy a barrel of oil. Starting in the summer of 2007, the price of oil began to rise rapidly and wage growth slowed. The result was a doubling in the price of oil and more than a doubling in the number of hours of work required to purchase a single barrel of oil. It took more than six hours of work to make this one barrel of oil purchase in June 2008.
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Using hours worked to scale oil prices is useful, because it provides a sense of how oil price increases impact the terms of trade. Turning the ratio around provides an estimate of the amount of oil one hour of work can buy for the average worker. When wages stagnate and the price of oil doubles, the same fixed amount of labor can now only buy half as much oil.
Given that the amount of oil consumed is thought to be price-inelastic, the consumer tends to purchase the same amount of oil but reduces expenditures (or savings) elsewhere. Relative prices have to adjust further (competing goods and services have to fall in response) or non-oil output will contract.
This is especially consequential for the U.S. because the nation imports 11.1 million of barrels of oil per day. Rather than transferring consumption expenditures from one domestic industry to another, an oil price increase transfers dollars abroad. A 30% increase in the price of oil translates to a 30% increase in the amount of hours the U.S. labor force has to devote to paying its oil import bill. Rather than leading to higher standards of living, productivity increases then only help to stabilize the number of hours supplied to cover oil imports.
As shown in the graph below, the U.S. oil import bill reached a peak of $600 billion in June 2008 on an annualized basis (the price of oil multiplied by the number of barrels imported that month, times 12).
This oil import bill virtually guarantees the U.S. runs large trade deficits because it requires the U.S. to run a surplus of more than 4% of GDP in all other categories of goods and services to achieve balance. Unfortunately, the amount of labor hours devoted to paying the oil bill greatly reduces the economy’s ability to generate large gains in other tradable sectors. The 65% rise in the current account deficit (trade balance plus transfers and income derived from selling the services of factors of production) since the second quarter of 2009 demonstrates the linkage between oil and the U.S. trade balance.
What are U.S. policymakers to do? The likely response is an energy plan aimed at increasing the failed subsidies for renewable fuels. This is unfortunate not just because it’s a huge waste of money, but also because it distracts from the real issues. Part of the oil price increase is an unavoidable consequence of economic growth.
As shown in the chart below, the price of oil and U.S. GDP growth are closely correlated. As U.S. output collapsed, so too did the price of oil. As the U.S. economy rebounded sharply off the bottom (5% real growth in the fourth quarter of 2009), the oil price rose at its fastest rate in many years. In short, the data since the middle of the last decade suggests that the oil price and supply elasticities are such that continued growth in the U.S. and world economies are likely to result in significant and sustained increases in the price of oil.
But part of the oil price increase is also tied intimately to currency policy. While oil price increases are tightly correlated with, and partially driven by, increases in GDP, the price run-up since August came during a period when the U.S. economy grew at a below-trend growth rate.
The blue line in the graph above captures the date when Bernanke gave his Jackson Hole address announcing another round of quantitative easing. While GDP growth has been flat since that time, the price of oil has surged. The aim of U.S. monetary policy over the past eight months has been to engineer declines in the value of the U.S. dollar against virtually all tradable assets. One manifestation of this policy has been a decline in the number of barrels of oil that $100 can buy from 1.4 in August 27, 2010 to 0.96 barrels today.
The data clearly suggest at least some of the increase in the price of oil is attributable to the desire of investors to diversify into physical commodities like oil, with much of the rest attributable to the expectations of future price and output increases likely to be engineered by quantitative easing.
Oil price increases exact a huge toll on the U.S. economy. A monetary policy that helps to engineer large increases in the price of oil is unlikely to be in the national interest, no matter what ancillary benefits it achieves. While the Fed cannot do anything to eliminate the linkage between oil prices and GDP growth, it can help to ensure that oil price increases are a product of supply and demand factors and not simply an outgrowth of a desire of savers to diversify out of dollars and into physical commodities.