What Higher Gas Prices Could Do to the Economy

1679
With the average price of gas nationwide topping $5 per gallon Saturday, surging fuel prices across the United States are creating new strains for millions of consumers and businesses, while compounding intractable political challenges for the Biden administration.
The spike in gas, oil and diesel prices has saddled all kinds of businesses with higher costs that will force them to raise prices on their customers and pull back on new investments. It risks a slowdown in consumer demand, as households cut back on other expenditures to accommodate their new fuel costs. Gas purchases on their own make up only a relatively small portion of most families’ budgets, but energy is so crucial to the functioning of the economy more broadly that the price increases bring along higher prices in many other sectors.
The soaring prices show no sign of abating in the immediate future, as global forces continue to prevent disrupted supply from keeping up with strong demand from countries that are rebounding quickly from the pandemic. Western sanctions against Russia over its invasion of Ukraine have wreaked havoc with global energy markets, but the most dramatic measure, the European Union’s ban on Russian oil imports, will not even go into effect until the end of this year. Gas prices could also be further pushed up by drivers hitting the road for summer vacations, and the lifting of covid restrictions in some Chinese cities is expected to lead to rebounding fuel demand there, putting further upward pressure on prices internationally.Rising oil and gasoline prices are once again threatening the U.S. economic recovery. It is no surprise that the root cause is geopolitical turmoil in the Middle East – this time related to Iran’s nuclear ambitions and potential disruptions in oil supplyAt this point, it is the threat of Iranian oil supplies being removed from the market that is pushing prices higher. Saber rattling by Iran is contributing to the speculative price spike, perhaps a key strategy to maximize its oil revenue even with weaker volumes. West Texas Intermediate (WTI, the leading benchmark in U.S. oil pricing) passed the $100 threshold and crossed $110 per barrel briefly. Brent crude, the other pricing marker, surpassed $120 per barrel.
Rising oil prices will harm U.S. economic growth. But what is the likely magnitude? Higher oil prices have played a role in U.S. recessions since 1973. But correlation doesn’t necessarily translate into causation. Causation depends on a number of factors and transmission through the economy and, most importantly, whether the Federal Reserve tightens monetary policy in respond to higher oil prices. Furthermore, the impact is conditional on expectations of whether the price increase is transitory or longer lasting.Consumers. As higher oil prices manifest themselves in downstream prices of gasoline, diesel and other refined petroleum products, they force consumers to shift discretionary spending away from big-ticket purchases of autos, furniture and appliances. Higher oil prices also crimp consumer purchases of nondurables–if you’re paying more at the pump, you’ve got less to spend on shoes, dining out and going to the movies. In many respects, higher oil prices act as a tax on consumers, and most of those dollars move out of the United States.

Consumer demand for gasoline is the biggest end-use category. American consumers purchased 172.2 billion gallons of gasoline in 2011, spending just over $400 billion, excluding federal and state taxes. Each 50 cent increase in the price of gasoline adds almost $60 billion to annual consumer bills, roughly the spike over the past few weeks. In the short-term, the price elasticity of demand for gasoline is fairly inelastic (not sensitive). The most immediate response is for consumers to alter their behavior. Households reduce their leisure driving and use more public transportation. Additionally, consumers shift more transportation fuel purchases to alternatives such as a higher blend of ethanol.

Consumers have adjusted their spending patterns on gasoline since the 2007 spike in prices. On a per capita basis, consumer demand has fallen from 610 gallons in 2006 to about 550 at the end of 2011 (see chart), a reduction of almost 10 percent. Overall, consumption of gasoline is down by nearly 7 percent over the same period.

RECOMMENDED FOR YOUMORE FROM AUTHOR