The ripple effect of prices at the pump

Higher gas prices could put a drag on the recovery.

By , Staff writer of The Christian Science Monitor

Hold on to your wallets.

Those record gasoline prices are expected to climb even higher just as the summer driving season gets under way.

The problem is tight supplies - a product in part of the war in Iraq - combined with increased demand as a result of economic recovery in the US and Asia. Add to that mix OPEC threats to tamp down its spigot, and oil experts predict that prices at the pump this summer will run from the current record high of $1.74 a gallon to $2 a gallon.

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That said, no one thinks the price spike will prompt families to sit home in the summer heat or suddenly switch to solar energy, although some may choose a cabin in the woods closer to home.

Yet some economists are predicting an uptick in the cost of consumer goods from shoes to strawberries, as truckers' pricey trips to the pump are passed on to retailers and then on to you. Indeed, some believe gasoline prices are already putting a drag on the so-called jobless recovery. Come Memorial Day, they predict gas costs could put a damper on consumer spending, slowing the pace of recovery even further.

But others contend the price spike will have little impact, other than a touch of personal frustration when drivers reach for their credit cards. They note that inflation so far has remained fairly low - in part because the high price of gas is being offset by other deflationary factors, such as the low cost of housing, thanks to the refinancing boom.

The two competing camps do tend to agree on one thing: Gas prices will have to spike far higher than $2 a gallon for them to derail the current recovery.

"As shocking as the oil prices are, they're not shocking enough to knock us into a new downturn," says Lakshman Achuthan, managing director of the Economic Cycle Research Institute in New York. "The window of vulnerability that was open a year or two ago in this economy has slammed shut."

But even optimists say there could be a few dark clouds on the horizon. If crude oil prices stay high - which most analysts think they will, barring a sudden change - that could put a crimp in consumer spending and the pace of recovery.

"My expectation is that the higher oil and electricity prices are going to take a serious bite out of consumer budgets in the second or third quarter, and we're going to see unexpected shortfalls in economic growth by the third or fourth quarter," says economist Philip Verleger, a visiting fellow at the Institute for International Economics in Washington.

To get a sense of just how big that bite is, figure that every 1 cent rise in the price of gas takes $1 billion dollars out of Americans' pockets. So if gasoline does increase to $2 a gallon, it could offset the entire impact of this year's tax cuts. "It means that all of the tax breaks the Bush administration has given the consumers will end up going to the oil companies, OPEC, and sellers of electricity and natural gas," says Dr. Verleger.

There are several reasons that gas prices are so high, and they are related to that Economics 101 concept of supply and demand.

First, is understanding why world reserves are so low. In part, it has to do with the Iraq war.

Other oil producers expected that Iraqi oil fields would be producing large quantities of crude by now, so they didn't ramp up their output. But that hasn't happened because of the continuing chaos there. Second, there was some lingering pessimism about the pace of the world's economic recovery, which kept many buyers from replenishing their stocks. And finally, OPEC recently announced that, as of April 1, its countries would cut back production by 1 million barrels a day. But then, some OPEC countries hedged. And that breeds uncertainty into the world market.

"Higher prices sometimes are not the problem in themselves. It's that people can't rely on what those prices are going to be. There's no sustainability on prices, no reliability on oil supplies," says Mark Baxter, director of the Maguire Energy Institute at the Southern Methodist University in Dallas. "The traders and buyers don't know how to react, except to buy and put the price up."

The demand side has both good and bad news. The economic recovery and the start of the summer driving season are on the positive side of the equation. But both those factors increase demand, which increases prices.

So, experts say, drive wisely, and plan to pay as much as $2 a gallon this summer. "That should not really affect vacation plans," says Mr. Baxter. "But Americans should be aware of efficiency and conservation, and manage their driving habits.... [They should] minimize the number of trips they make for shopping and picking up kids, that kind of thing."

Another less obvious factor in the tight supply of oil is the steady erosion in the value of the dollar. OPEC sells its oil in dollars, which have lost more than 10 percent of their value in the world market, according to some analysts. To make up the difference, OPEC has cut back production to keep the oil prices high.

Jeremy Rifkin, president of the Foundation on Economic Trends in Washington, says this could produce "a perfect storm" that could plunge the economy into a deep recession by Election Day. That's if everything lines up: Gasoline prices spike to $2.50 to $3 a gallon, which impacts consumer spending and companies' willingness to invest, which drags down the economy. To stimulate it, the government either gives another tax break or increases spending. Either way, it increases the record deficit, which already is making foreign investors nervous. So in order to finance the debt and attract those investors, the government raises interest rates, which again will have a negative impact on the economy.

"It could have a tsunami effect," says Dr. Rifkin, "which could bring the economy to a screeching halt, plunging it into a deep recession by the November election."

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