Oil and the Recovery

A commenter asked me if I thought the current price spike in oil changed my outlook.

First, I believe the evidence is clear: the U.S. economy is in the middle of a recovery. We've had six straight quarters of GDP growth, a solid manufacturing sector and a recovering service sector. Other countries are growing, which is giving strong support to U.S. exports. PCEs are now higher on an inflation adjusted basis than pre-recession levels. The two laggards are employment (which is typical as it is a lagging indicator) and housing (which will be a problem area for the next year at least). So, will the current spike in oil prices derail the recovery?

I don't believe we are there yet for several reasons. First, the events in the oil market are only a week old. (although they seem to have gone on far longer). Second, I think the overall economic recovery now has legs -- the recovery is no longer fueled by government spending and inventory restocking but by broader based foreign and domestic demand. As previously mentioned, PCEs are up and increasing; retail sales (a smaller subset of this data) are also doing well. Businesses are investing and commercial real estate is coming back. While the increase in demand is still new, it is there. A broader economic recovery implies one that is harder to slow down by external shocks.

Professor James Hamilton -- on whose judgment I defer to in most matters oil -- concurs in a recent post, where he concludes:

My bottom line is that events as they have unfolded so far are not in the same ballpark as the major historical oil supply disruptions, and are unlikely to produce big enough economic multipliers that they could precipitate a new economic downturn. They might shave a half percent off annual GDP growth, but I don't anticipate a whole lot worse than that.

But the worry of course is that the big geopolitical changes we've been seeing didn't stop with Tunisia, and didn't stop with Egypt. So maybe it's not a good idea to assume it's all going to stop with Libya, either.

Also consider this data point from Deutsche Bank:

According to our analysis, a $10 increase in oil prices translates into roughly a 25 cent increase in retail gasoline prices. Every one penny increase in gasoline is then worth about $1 billion in household energy consumption. (In decimal terms, it is actually $1.4 billion.) Therefore, a sustained $10 increase in oil prices translates into $25 billion in additional household energy spending. Assuming this price rise crowds out spending elsewhere in the economy, effectively acting as a tax, means that a sustained $10 rise in oil prices reduces annual real GDP growth by 0.2%. Therefore, we would need oil prices to rise substantially from their current level and then remain elevated for some time before becoming more concerned about economic growth.

And Macroadvisers weights in with this:

An increase in oil prices of $10/bbl for one year starting in the first quarter of 2011 would:

• Reduce GDP growth by about 0.3 percentage point over the first half of the year and by 0.2 percentage point over the entire year.
• Headline PCE inflation would be about 0.1 percentage point higher over the year, and the unemployment rate about 0.1 percentage point higher.

.....

Nevertheless, these results suggest that if the energy futures markets have the extent and magnitude of the crisis in North Africa and the Middle East properly gauged, the economic fallout for the U.S. is likely to be relatively modest.

An important caveat is that the simulations reported here assume that product prices, the prices that really matter, will move proportionally with crude prices. However, since the shift toward diesel fuel consumption in Europe has put a premium on light sweet crudes, the relationships among the prices of oil of varying qualities has changed dramatically of late. As a result, the relationship between any particular crude price and product prices has also broken down. This fact puts a somewhat larger confidence interval around these results than would be the case if these prices were more or less moving together as they have historically, over most periods.

Also see this article at Angry Bear.

Let me add a few caveats.

First, as I mention above, this has only been going on for a week. The longer this lasts, the greater the damage that can be done to the economy. Think of it as a sliding scale. However, looking at the price chart, we see a price spike last a few days, not weeks. That's a very important point to make.

Second, consider professor Hamilton's second paragraph. As this wave of change sweeps the Middle East it is entirely likely we'll see profound change in the oil market. That uncertainty will increase prices -- and the more uncertainty the worse the effect will be (leading to higher prices).

However, so far, I would simply classify recent events as a "bad week" of data that can easily be resolved by a peaceful resolution to the ME situation.