Effect of oil spikes on GDP

Oil Implications And Fed Policy

Zero Hedge,

7 March, 2012

Oil is battling hard with Greece to top the tail-risk-du-jour in financial markets recently. As Credit Suisse notes, the US economy so far seems to have shrugged it off as 'gasoline-sensitive' economic data for Feb have ignored the price rise for now. 

The extreme (warm) weather may be shielding the economy from the effect of these higher energy costs, as are consumers habituation with relatively high prices, and while CS remains more sanguine than us on energy's negative impulse they set forth some useful implications (rules-of-thumb) for what oil means for gas prices, headline inflation, real disposable income, and GDP growth pointing to $150 Brent as a critical threshold for the economy (or equivalently $4.50 retail gasoline prices). 

Of course, Fed policy precedents and implications are necessarily situational as the hope for this being a 'temporary' situation but the circular reaction to the consequences of any growth drag will merely exacerbate the situation. 

Was Bernanke's recent less unconditional dovishness an implicit effort to 'tighten' expectations and manage the war-premium out of oil prices?

"There are “rules of thumb” we can apply for inflation, gasoline spending, and real income that are helpful for analytical purposes, although the actual impact on the economy is more

complex.

• For every $1 rise in the price of oil, gasoline prices rise by about 2.5 cents at the pump.

• Every penny rise at the gasoline pump adds slightly more than $1bn to the household sector gasoline bill (assuming no alteration in driving behavior).

• Every $10 increase in the price of crude oil raises headline CPI inflation by 0.3-0.4 ppt.

• Every $10 increase in the price of crude oil reduces real income growth by 0.3-0.4 ppt.

• And for the impact of oil price shocks on GDP growth..."

In our central scenario, our simulation suggests that real GDP growth would emerge relatively unscathed, with GDP predicted at 2.5% annualized by Q4. This result comes very close to the current consensus estimate (2.6% based on February Blue Chip) and our own forecast (2.3%).

The “high” scenario assumes a somewhat faster oil price increase and predicts slightly slower growth. Our simulation suggests that real GDP growth would slow down to 1.8% by Q4 this year, close to the average bottom ten Q4 GDP forecasts in the February Blue Chip (1.7%), though similar to the 2011 GDP performance.

Oil and Fed Policy

The reaction of monetary policy to increasing energy prices is necessarily situational. A persistent rise in the oil price that feeds into inflation expectations would require a much different policy response from an oil price rise that imparts a temporary boost to headline inflation. In his Monetary Policy Report testimony last week, Fed Chairman Bernanke did not dwell on recent energy price movements. But even his limited comments were telling:

“Looking farther ahead, participants expected the subdued level of inflation to persist beyond this year. Since these projections were made, gasoline prices have moved up, primarily reflecting higher global oil prices--a development that is likely to push up inflation temporarily while reducing consumers' purchasing power. We will continue to monitor energy markets carefully. Longer-term inflation expectations, as measured by surveys and financial market indicators, appear consistent with the view that inflation will remain subdued.”

The critical word in Bernanke's text is “temporarily.” It implies that the chairman, and his many like-minded colleagues on the FOMC, are more concerned about the headwinds that higher gasoline prices might impose on economic growth than about gasoline’s potential influence on general price levels and inflation expectations. The menu of policy responses, then, includes doing nothing and easing further. Tighter policy in this scenario would be seen by the majority of FOMC voters as a dangerous over-reaction.

This view would be consistent with earlier research performed by Professor Bernanke (and colleagues) in the 1990s, which showed that "a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increases in oil prices per se."

For article GO HERE