Oil: Shocks, But No Megashocks

Thank the economy and technology

Even an oil shock that jolts the price per barrel to $50--an increase of 67% above the current price of about $30--could be absorbed by the U.S. economy. That's the conclusion of a new report by William C. Dudley, director of U.S. economic research for Goldman, Sachs & Co. While inflation would certainly rise and economic growth might slow, neither effect would be severe or long-lasting, he argues.

To be sure, oil price hikes of that magnitude aren't something to take lightly. "The past three economic downturns were precipitated, in part, by higher oil prices," writes Dudley. For example, an increase that brings the price to $50 a barrel--up from about $21 a year ago--is roughly equal in percentage terms to the one that rocked the economy during 1978 and 1979.

But the economy is far better prepared to handle an oil shock this time, in part because businesses and consumers use oil much more efficiently than they did a few decades ago (chart). Indeed, despite the recent attention paid to fuel-guzzling sport-utility vehicles, real gross domestic product per barrel of oil has continued to rise in recent years. Over the past five years, real GDP is up by more than 20% while oil consumption has increased by only 9%.

In addition, today's low inflation rate, combined with the tremendous inflation-fighting credibility enjoyed by the Fed, means that the economy can more easily absorb an increase in oil prices without starting an inflationary spiral. The 43% oil price increase of the past year had practically no effect on inflationary expectations or on consumer confidence and financial conditions, says Dudley.

Also, any oil price shock is likely to be short-lived because technology has reduced the cost of exploring for new oil. "The long-run equilibrium price for crude oil is only about $17.50 a barrel," writes Dudley--far below the current price. That means eventually the supply will increase enough to hold down the price of oil, even if prices spike in the coming months.

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