Oil Prices and the U.S. Economy: Some Rules of Thumb

Where we go from here is highly uncertain. Will Libya stabilize? Will its oil flow resume? If not, will others (i.e., Saudi Arabia) step in to cover any supply shortfall? Will turmoil spread to other Middle East oil producers?

This note does not pretend to answer these questions. What it does is provide some guidelines—some rules of thumb—to bear in mind when thinking about the impact of higher oil prices on the U.S. economy.

We will split the discussion into two sections—simple arithmetic rules of thumb that describe how oil prices affect gasoline prices and real incomes, and behavioral rules of thumb that reflect how those price changes affect the economy in IHS Global Insight's model of the U.S. economy.

Arithmetic Rules of Thumb

Since a barrel of oil contains 42 gallons, a $10 rise in the price of a barrel fully passed through will raise the pump price of gasoline by about 24 cents.

Based on the latest weights, as of December 2010, gasoline made up 4.9% of the consumer price index. At December's gasoline price ($3.03/gallon on average), a 24-cent rise in gasoline prices would raise the price by 7.9%, which would add 0.4% to the consumer price index (CPI). A 24-cent rise added to today's higher gasoline price would be a slightly smaller percentage increase, but would still add the same 0.4% to the CPI.

The effect on the personal consumption price index—which is used to determine real incomes—would be smaller than on the CPI. Gasoline has a smaller weight in personal consumption, perhaps because some of the gasoline spending in the CPI may be classified as business purchases in the national income accounts, and therefore is not included in consumer spending. As of December 2010, consumer spending on gasoline was 3.6% of total consumer spending, so a 7.9% rise in the gasoline price adds 0.3% to the personal consumption price index. This corresponds to an extra gasoline spending bill of $29.6 billion, assuming no change in the volume of gasoline purchased.

Behavioral Rules of Thumb

The IHS Global Insight model of the U.S. economy factors in not only the direct effects on consumers of higher gasoline prices, but also filters through higher petroleum costs to other prices. It also factors in multiplier effects—i.e., if consumers cut spending because gasoline prices are higher, that will reduce somebody else's income and in turn reduce their spending.

We have run a simulation that assumes a permanent $10/barrel rise in the price of crude oil. We have assumed that the federal funds rate is held at baseline levels. Headline inflation would be higher but activity would be lower, so the Federal Reserve would be unlikely to raise interest rates in response (the inflation-phobic European Central Bank might react differently—which may explain why the euro has been rising in recent days).

We have also assumed that GDP in the rest of the world is lower, hurting export demand. The current episode is a supply shock, so it makes sense to assume that activity around the world is lowered.

In the first year, real GDP and real consumer spending are both reduced 0.2% below their baseline level. The CPI is 0.5% higher, and employment is reduced by 120,000.

If the higher price persists, then as multiplier effects accumulate, the cumulative loss in real GDP rises to 0.5% in the second year, and the employment losses reach 410,000. These second-year effects are measured relative to baseline, which means that the growth impact in the second year is the difference between the second- and first-year effects (i.e., GDP growth in the second year is reduced by 0.3%).

Tipping Points and Threshold Effects

The macro model responds in a roughly linear fashion to oil price shocks; the effect of a $20 hike in oil prices is roughly twice the effect of a $10 hike. So the roughly $15/barrel rise in Brent prices since the start of the year—if sustained—would take about 0.3% (one and a half times 0.2%) off the 2011 growth rate.

Some analysts have found evidence of "threshold effects" that may make the impact nonlinear. A recent perspective note by IHS Global Insight economists Chris Christopher and Greg Daco [1] discussed evidence that when gasoline prices hit round dollar values like $3 or $4, there is a noticeable jolt to consumer sentiment.

In the present context, the most obvious candidate for a "tipping point" in the United States would be $4/gallon gasoline prices. It would probably require another $20/barrel added to the oil price (i.e., around $120/barrel for WTI or around $130/barrel for Brent) to take gasoline prices through the $4/gallon mark this summer driving season. Compared with where we began the year (around $95 for Brent) that would mean a drag on GDP growth of 0.7% from the $35 hike (three and a half times 0.2%), plus whatever extra damage might kick in from the "threshold effect" of passing the $4/gallon mark. At that point, the damage to growth would start shifting from an irritant to something worse.

by Nigel Gault

[1] "Gasoline Prices and Reality," Chris G. Christopher, Jr. and Gregory Daco, January 27, 2011. Note that the simulation results in their article are presented as effects after four or eight quarters, rather than annual averages as above.