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Oil has crossed the $100 threshold a couple times in the last day or so, but there’s still a lot of confusion over what that means. To be sure, predicting the economic consequences of a spike is tough. Nonetheless, a few guidelines are worth keeping in mind.For the most part, a price increase needs to be sustained to be badly damaging. Cliff Krauss describes a basic rule of thumb in a good article in today’s Times: “As a general rule of thumb, every $10 increase in the price of a barrel of oil reduces the growth of the gross domestic product by half a percentage point within two years.” That sounds roughly right. The U.S. imports about 10 million barrels of oil each day; 10 dollars per barrel sustained over two years adds up to about $70 billion. That’s about half a per cent of GDP (or about a quarter of a percentage point drag each year). But if a price spike isn’t sustained, it doesn’t add up to as much. If, say, oil hits $100 rather than $80 for a month, the impact (using the same rule of thumb) would be cut by a factor of 10, adding up, perhaps, to a 0.05% hit to growth this year. Even a monthlong spike to $180 would still, by this crude estimate, only slice about 0.2% off annual growth.
Oil price spikes, though, don’t just affect output directly. Historically, monetary policy has been central: if higher oil prices lead to higher inflation, that can prompt rate hikes from the Fed and lead to slower growth. But a spike generally needs to be sustained before it can affect broader prices, and until that happens, it won’t influence policymakers. (The Fed doesn’t include oil prices in the measure of inflation that it watches as it decides rates.) In addition, given the amount of slack still in the economy, it could take a lot to send inflation way up.
There’s one big caveat to all this: There’s decent research that suggests that it’s consumer confidence, not oil prices per se, that affect consumer demand, and hence economic output. By this accounting, even a big oil price spike need not have a huge economic impact, so long as consumers aren’t shaken. Conversely, though, even a superficially modest spike can have big consequences if consumer psychology is deeply affected. This dynamic, rather than any of the other more mechanical ones, may be the most important to watch.
This post originally appeared at Council on Foreign Relations.
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