Oil and the Economy

The rise in oil prices is expected to have mixed effects on the U.S. economy. Higher gasoline prices will restrain consumer spending growth to some extent. However, increased energy exploration implies more capital spending, adding to GDP growth. For Federal Reserve policymakers, the key question is whether higher costs of transporting goods may be passed along to consumer prices. This adds to the Fed’s difficulties in achieving a soft landing for the economy in the months ahead.

The increase in U.S. energy production has reduced our reliance on foreign oil in recent years. However, oil is still a global commodity. High prices overseas mean high prices here. Political tensions in the Middle East and problems in Venezuela should leave oil prices higher for the foreseeable future.

Scott Brown
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The increase in gasoline prices has already had a noticeable impact on the consumer. Average hourly earnings, adjusted for inflation, are roughly flat on a year-over-year basis. The typical worker may be seen as running in place. You can still get gains in aggregate consumer spending, due to job growth, but the overall pace of spending growth is likely to be somewhat limited. That’s important, since consumer spending accounts for about 69% of Gross Domestic Product.

In the Great Inflation of the 1970s and early 1980s, higher oil prices boosted the Consumer Price Index. Many union wage contracts had inflation clauses in them, and non-union wages typically followed what was happening to union wages. The increase in the CPI fueled wage inflation, which in turn, added to consumer price inflation – a vicious cycle, which required a major recession in the 1980s to begin wringing inflation expectations lower. That lesson isn’t lost on the Fed.