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Thursday, August 18, 2005

Oil's Impact on the Economy

by Calculated Risk on 8/18/2005 08:16:00 PM

Several blogs are commenting on oil's potential impact on the economy. First a quote:

"People are able to pull money out of their homes and put it into their gas tanks," said Mark Zandi, chief economist at Economy.com. "So the overall effects on consumer spending have been small."
Mortgage extraction to purchase consumables is probably not a viable long term strategy. Dr. Roubini comments:
Until now consumers have reacted to the oil shock as if it was a temporary shock: when a shock to real income is temporary it is optimal to maintain the consumption level and reduce savings in face of reduced real income. But if the shock is persistent or permanent the rational response to the reduced income should a reduction in consumption equivalent to the permanent reduction of income with little effect on savings. U.S. consumers have reacted so far to the oil shock as if it was temporary and they have further reduced their savings rate down to zero; but two years of large and protracted increases in oil prices suggest that part of the shock is permanent. With already stretched and slow-growing incomes, U.S. consumer have dipped into their rising housing wealth and borrowed more and more against it, in part to finance the real income shock from higher oil prices.
Professor Hamilton expresses concern that consumer psychology might be changing:
In my opinion, the reason that the oil price increases of the last two years have not caused a recession yet is that they have built up gradually, and resulted not from a drop in supply but instead from strong global demand. Faced with a gradual price increase and rising incomes, most people have been able to adapt to the higher prices and make adjustments in an orderly way that does not cause serious economic dislocations.

On the other hand, just within the last couple of weeks, I've been hearing a lot more expressions of anxiety and concern-- the sort of psychological factors that produce abrupt spending changes.
Barry Ritholtz, who is already predicting a recession in 2006, also comments on consumer psychology:
While Oil may be a much smaller percentage of GDP today than it was in the 1970s, the relative financial conditions of indebted consumers may also be that much less able to absorb an extended shock than it was then.
...
Record high gasoline prices, that fall back a little but stay inflated; Add a housing boom that doesn't crash, but merely fizzles. The ongoing refinacing machine which drove so much consumer spending decellerates rapidly. Add to it a War which the majority of the country now believes turns out to be "Not worth it" and a significant percent (though not quite a majority) beleives we were led into under "false premises." Lastly, the myriad stimulus from the government -- tax cuts, ultra low interest rates, deficit spending, increased money supply, military expenditures -- all begin to fade.

What might all this a recipe for?
And as usual, I provide a few graphs over on Angry Bear. Dr. Roubini concludes:
Is there a risk of an outright recession? Probably not as consumption is still firm and labor market conditions are modestly improving. But a significant U.S. growth slowdown by year end to a level below the 3.5% U.S. potential growth rate cannot be excluded: growth slumping towards the 2.0-2.5% range by early 2006 cannot be ruled out if oil prices remain at current level. And the expectation that the Fed may ease in face of such economic slowdown may prove incorrect: with a housing bubble and a large current account deficit and a core inflation rate that may be creeping soon above 2% the Fed may not be able to afford to ease if the economy slows down. In 2003 when the concerns were about deflation, the Fed reacted to the pre-Iraqi war oil spike and economic slowdown by reducing the Fed Fund rate to 1%. Today, with inflationary pressures modestly creeping up the Fed would face a much tougher dilemma if the latest oil shock turns to be, as likely, stagflationary.

So, if oil prices remain at the current levels or increase further there is not yet the risk of an outright recession but certainly a high probability of a significant economic slowdown by year end and into 2006.
I have a similar view (from my AB post): My view (not Angry Bear) is a combination of a housing slowdown and high energy prices will probably lead to an economic slowdown next year, and possibly a recession.