Barreling down the road to recession

Abstract

The steady rise in oil prices since 2002 has evoked concern about possible negative effects on the economy.1 Could current energy prices push the United States into recession? Many economists have studied this question—in particular, how oil shocks affect both economic growth and inflation. When consumer demand shifts away from energy-intensive goods as a result of rising oil prices, output declines in the near term as industries’ capital and labor adjust. Timothy Bresnahan and Valerie Ramey studied the effect of the oil shocks of the 1970s and early 1980s on the automobile industry. Specifically, they examined how changing demand from standard-sized vehicles to smaller, more fuel-efficient cars affected the economy. They found that capacity utilization—the ratio of total cars produced to potential cars produced without using overtime—fell from above 100 percent in 1973 to around 50 percent in 1975. Similarly, capacity utilization fell from 100 percent to around 40 percent in 1982.2 Both instances followed sustained high levels of gasoline prices, which caused such a shift in consumer choices. Today’s high gas prices may do the same. The National Automobile Dealers Association reported that year-to-date SUV sales were down 19 percent in July compared with the same time last year. Steven Davis and John Haltiwanger examined the effect of oil price shocks on manufacturing employment between 1972 and 1988. They found that the sharp rise in oil prices in 1973-74 led to an 8 percent decline in employment after two years and total job reallocation (job destruction plus job creation) of 11 percent after four years. In the short term, job reallocation was higher in industries that may require more time to adjust labor and capital (e.g., apparel, rubber and plastics, furniture, primary metals, and transportation equipment).3 Steep increases in oil prices might also translate into inflation of prices for other goods by increasing the cost of production. Mark Hooker examined the effects that oil has on personal consumption expen diture inflation, excluding food and energy (core PCE inflation). He found that, before 1981, a doubling of the price of oil would lead to a 3-percentage-point increase in core PCE inflation.4 The stance of monetary policy, however, ultimately dictates long-run inflation. Since 1981, the Fed has adopted a more anti-inflationary stance of monetary policy, potentially lessening economic disruption from oil price changes.5 Indeed, Hooker found that, post-1981, oil price increases have had statistically no effect on core PCE inflation. Finally, can we expect a recession to occur as a result of current oil prices? James Hamilton believes that oil shocks affect economic growth only when, as a result of the higher prices, consumers’ spending behavior changes.6 As the accompanying chart shows, PCE growth has remained positive since the real price of oil began to rise. The negative PCE growth that accompanied the previous oil shocks has not yet occurred during the current run-up in oil prices. Thus, as of now, economic growth appears to be more resilient to the negative effects of rising oil prices than in the 1970s and early 1980s.