Why Oil Didn't Ignite an Economic Inferno

Soaring per-barrel prices should have seen inflation soar, but as they hit their peak, it didn't happen. Here are some possible explanations

By Michael Englund

Was the surge in oil prices in the second half of 2004 just an illusion? It may seem that way given the surprisingly small impact on U.S. economic data. Though the market price run-up of crude was real enough, the energy industry -- and economy overall -- was seemingly not as exposed to this price swing as in prior price spikes.

One example: Higher wholesale crude through the August-October period only marginally passed through to retail gasoline prices. It may well be that through hedging strategies, energy-dependent companies were well prepared for price swings prior to the Presidential elections. Meanwhile, speculative hedge funds may have exacerbated the price volatility through aggressive buying of crude futures.


  Market-price data for oil suggest that the general uptrend in oil prices since the turn of the year gained considerable momentum during the July-October period. That would imply that U.S. domestic-inflation measures should have accelerated in the second half of the year as well. Using prices of the benchmark West Texas Intermediate (WTI) grade as a gauge, oil prices fluctuations in the $25 to $35 per barrel range since the start of the current economic expansion were replaced around the end of 2003 with an uptrend through midyear to the $40 area, where it appeared poised to establish a peak.

This hefty 33% price jump in the first half of the year explained substantial unexpected inflation pressure in the chain-price indexes of quarterly gross domestic product reports, as well as the consumer- and producer-price index reports over the period. The chain-price indexes revealed growth rates of 2.8% in the first quarter and 3.2% in the second, with even bigger gains of 3.3% and 3.1%, respectively, for the personal-consumption chain-price indexes. All of these figures were roughly a full percentage point higher than was expected at the start of the year.

The Consumer Price Index figures revealed oil-led quarterly growth rates of 3.6% in the first quarter and 4.7% in the second, while Producer Price Index posted characteristically more volatile gains at rates of 3.9% and 6.1%. These price gains reflected the normal sensitivity of domestic-price measures to energy price swings.


  But after a summer pause, WTI prices surged to around $55, which reflected another 37% rise over a very short three-month period. Given the surge through the end of October, which left a whopping $53-a-barrel average reading, one might expect even greater upside domestic-inflation pressure during the third and fourth quarters than was seen in the first two.

And yet the third-quarter data revealed a sharp and remarkable slowing in the GDP chain-price index -- to a 1.3% rate of increase, with an even more modest 1.1% rate of growth for the Personal Consumption Expenditure chain-price index. These gains are nearly a full percentage point below the 2% to 2.5% trend figures that were expected at the start of this year, and they actually "gave back" strength in the first half of the year despite the accelerated oil price uptrend. CPI posted an anemic 1.9% growth rate in the third quarter, while PPI was nearly flat with a 0.6% gain.

We expect some unpleasant inflation figures in the PPI and CPI reports for October, which will allow the domestic-inflation measures to play a bit of catch-up. Yet, even with projected headline PPI and CPI gains of 0.7% and 0.4%, respectively, there's little evidence of a fourth-quarter price surge. Domestic gasoline prices appear poised for a 3% drop in November, as falling wholesale-oil prices have been quick to translate to declining retail costs, even after the rise in wholesale prices failed to reveal a full pass-through.


  By our estimates, the CPI and PPI indexes are likely to post growth of only about 3% in the fourth quarter, which leaves price growth through the second-half of the year at roughly 2%, despite the summer oil-price surge. Both the GDP and PCE chain-price indexes should rise at only a 2.4% rate in the fourth quarter.

So have oil companies finally responded to the usual accusation that they are quick to pass through price increases, but slow to pass through declines, with the reverse pattern in the second half of 2004? A plausible explanation: Oil-sensitive industries hedged oil-price risks to the U.S. Presidential election early in the year, boosting their cost structures in the first half of the year, but leaving little effect in the second half. Market risk may have been taken on by hedge funds, which bid up oil prices through the second half of the year.

U.S. energy-sector companies also may have been hesitant to attract attention to retail gas prices in an election year, while some overseas buyers may not have minded the impact of higher wholesale-oil prices on the U.S. elections.


  Quite plausibly, all these factors contributed to what was a surprisingly large but short-lived surge in WTI prices, and an equally surprising lack of evidence of such price pressure in the U.S. domestic-price measures.

In total, the U.S. economy was largely buffered from both the run-up and ensuing freefall in market oil prices over the past five months, if the domestic U.S. inflation data are to be believed. Still, economists would likely do well to treat the real swing in market prices in the third and fourth quarters as an "illusion" with respect to the reported economic data, outside of a smattering of market reports that use actual oil prices as an input.

Englund is chief economist for Action Economics

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