By David Wyss and Beth Ann Bovino The recent surge in oil prices has rattled financial markets, sparking fears of an inflationary squeeze on the economy similar to the one that occurred in 1980. We at Standard & Poor's Economics believe that while the rise in prices is cause for concern, it's unlikely that 2004's economy will suffer the same kind of damage caused by earlier oil shocks. Higher energy prices should, however, slow the current U.S. recovery.
A perfect storm of heavy demand from China and the U.S. and fears of Middle East violence disrupting supplies drove prices for the benchmark West Texas Intermediate grade of crude oil to $41.65 a barrel on May 24. We think the geopolitical uncertainty has resulted in a more than a "risk premium" of more than $5 a barrel on top of already-high prices.
Peak crude prices in recent days have been much higher than the $39.94 average we expected for May and are 60% higher than their recent annual low average of about $25.90 a barrel in 2002. Based on the May 24 price, crude is nearly 44% above the $29 average level of the last three years.
MORE EFFICIENT. The recent run-up is still a risk for the economy, but not to the extent feared by investors. While higher oil prices indirectly tax consumers, squeeze corporate profits, and raise prices everywhere, the impact should be less severe than before. That's because energy consumption relative to gross domestic product (GDP) is lower than in the early 1980s. Household spending on energy in the first quarter is expected to be about 4.9% of real disposable income. This is up from 4% two years ago, but well below the 8.1% seen in 1980.
Moreover, the transition from a manufacturing-based economy to one in which services and information technology are predominant has reduced America's reliance on oil. Our models at S&P show that a $10 increase in oil prices will result in an expected 0.25% decrease in GDP growth for the year.
Still, though the economy is more energy-efficient than it was during the Carter Administration, the impact of rising oil prices will be significant. We expect the energy spike to reduce consumer spending by about $50 billion in 2004. Consumers, after shelling out more cash at the pump, will likely shy away from other purchases. Company profits will also be squeezed, at least for oil-guzzling industries such as airlines and chemicals.
QUICKER TIGHTENING? What does the oil pinch mean for the interest rate outlook? Well, the Federal Reserve focuses on the core rate of inflation (which excludes food and energy prices), which it tries to influence through monetary policy. Rising energy prices do seep into core inflation numbers through rising transportation and feedstock costs. Core consumer prices were up 0.3% in April from the previous month -- and 1.8% from a year earlier.
Although the year-over-year inflation rate remains well below that of the 1980s or even the early 1990s, it has jumped significantly, from only 1.1% in December. It's now near the upper end of the Fed's 1% to 2% inflation target.
We still expect a quarter-percentage point increase, to 1.25%, in the Fed funds rate at the central bank's June policy-making meeting. And the next tightening move after that is likely to come a bit quicker than expected -- probably before the November election. The Fed funds rate is likely to be 1.75% and possibly 2% by yearend. We expect a hike of three percentage points in the benchmark rate, to 4%, over the next two years.
All in all, the wild card of surging energy prices puts the Fed in a difficult position as it tries to balance economic growth and price stability. Investors may be thinking Alan Greenspan & Co. can sit back and let the oil-price spike slow the economy on its own, but the Fed may realize that it needs to go ahead and gradually increase superlow rates since the higher energy prices won't have as big an effect on the economy as they did 24 years ago. Wyss is chief economist and Bovino is a senior economist for Standard & Poor's