At a when hopes of expansion in economic activities are gaining ground, rising oil could play a spoil sport in dragging the U.S. gross domestic product or GDP. Though the current situation is completely different from the earlier one witnessed in 2008 when the oil price surged more than $150 a barrel, the effect of rising oil and gasoline price cannot be underestimated.
There is no doubt that consumers are aware of the effect of oil price in their household budget. Therefore, consumers have their own plan to face the rising fuel costs. But the run up in oil prices may have a different impact on economic activity. However, unlike earlier, the effect of rising oil prices leading to recession looks remote, views Wells Fargo in a research note to clients.
[Related -Integrated Device Technology Inc. (IDTI) Q1 Earnings Preview: Another Beat and Pop?]
Consumers' change their attitude during the rising oil price period is also quite understandable because higher oil prices act as a tax on consumption. As part of various efforts, they are adjusting to economic shocks overtime to cut down the number of miles they drive. Another point is consumers have become more versatile to adjust to gasoline shocks given the experience in 2008.
Importantly, rising gasoline prices often hurt consumer confidence level too. During the period of November 2007 to April 2008, gasoline prices ruled above $3.00 a gallon for six straight months. In the same period, consumer confidence dipped over 25 points. Wells Fargo believes that a one percent rise in gasoline prices is connected with a 0.2 percent fall in consumer confidence level with a one-month lag.
[Related -Herbalife Ltd. (NYSE:HLF) Q2 Earnings Preview: The Potential To Shock?]
Secondly, gasoline price changes impact income effect as well as substitution effect. The income effect will reduce consumption of gasoline as a sequel to rising prices. This will probably witness a fall in the number of miles driven by Americans, much similar to the 2008 scenario. Wells Fargo analyst sees there is little room for any substitution effect in the short to medium term because of difficulties in finding substitution in a short duration of time. But substitution level for the long term cannot be ruled out.
If one takes a look at the previous recessions, undoubtedly oil prices ruled higher. Therefore, the current run up in oil prices may remain a concern to policy makers. But though there is no immediate threat of oil prices dragging the U.S. to recession, it will have its negative effect on the growth of worldwide economy and the U.S. in particular. But how much unfavorable impact the rising oil price will have is a million dollar question.
A one percent rise in WTI lifts retail gasoline prices by 0.4 percent and a 10 percent increase in WTI to $117.9 from its current price of approximately $107.18 means gasoline prices increasing up to $3.87 a gallon from $3.72, Wells Fargo note indicates. This will threaten the consumers' threshold limit of $4.00 a gallon. Anything above this level could drag the consumer confidence at a faster rate. This means that WTI should increase to hit around $127.00 per barrel from the existing level of approximately $107.18.
According to an estimate of Wells Fargo, a one percent on $3.72, that is 3.72 cent, would entitle an additional $3.53 billion or 0.86 percent of $410.602 billion, which is the current level of PCE gasoline purchases. A $3.53 billion outgo means dragging of around 0.2 percent of nominal GDP. In a nutshell, one percent gasoline price increase would cut down nominal GDP by 20 basis points. However, other factors should remain constant for this; otherwise it could be much more.
But oil prices have been hanging around $100 per barrel for several years now and the economy seems to have adapted this price now unlike in 2004 when oil prices started this latest period of ever increasing oil prices. The expectation is that the U.S. economy could sustain unless there is a shock in oil prices. The shock could come from a potential conflict between Israel and Iran leading to a recession. But barring any such shock, Wells Fargo believes that existing oil price could allow the U.S. economy to witness upside but not at an optimum level.