March 12, 2004,
The average national price of gasoline has risen from $1.47 per gallon in mid-December to $1.74 in the latest week. This surge has reawakened fears that increased energy costs will put the brakes on economic growth. There are bound to be some negative effects from the higher prices, but they do not pose a serious hurdle for the economy.
Energy's role in the economy has changed substantially since the oil shocks of the 1970s. The economy consumed 16.7 thousand BTUs (or standard units) of energy per real dollar of gross domestic product in 1975, but that dropped to about 9.4 thousand in 2003, about a 44 percent decline. The drop is even more impressive when the energy source is petroleum, which fell from 7.6 thousand BTUs in 1975 to about 3.7 thousand in 2003 a more than 50 percent decrease.
The lessened importance of oil helps explain how the economy has been able to average 3.6 percent growth since the fourth quarter of 2001 even as the price of crude oil nearly doubled from $18 to $34 per barrel.
Consumers certainly feel the effect of higher gasoline prices. Gasoline is a relatively inelastic good, so spending for it will increase largely in proportion to a price increase. In round numbers, if the latest gasoline price was to hold for the rest of the year, it would mean that the 2004 average price would be about 15 percent higher than the 2003 average. In turn, that would imply a near 15 percent increase in spending on gasoline and less spending on other goods.
This sounds like bad news for economic growth. However, personal consumption expenditures on gasoline and oil were only 1.75 percent of nominal GDP in 2003, which is only slightly higher than the 1.66 percent average since 1990. If personal consumption remains the same as last year, the higher prices imply that about $30 billion extra will be spent on gasoline and oil in 2004. Considering that nominal GDP could increase by more than $710 billion this year (assuming 6.5 percent economic growth), the drag from the $30 billion "lost" to higher prices would amount to a couple tenths of a percentage point.
It is also worth noting that the "lost" spending estimate probably overstates matters as it is a static estimate. Income growth would offset some of the effect of the higher oil prices, and disposable income growth is on a strong uptrend posting 5.2 percent annual growth in January.
Actually, relative to gold, both oil and gas look overvalued. Over the past ten years, on average, an ounce of the precious metal bought 15.4 barrels of oil. Today an ounce buys only 11.2 barrels. If the ratio returns to the long-term average, oil prices could drop 15 percent to $30.5 per barrel.
Of course, if energy prices continue to climb, the effect on economic growth will naturally be larger. However, at this point, the effect will be that of a light braking.
John Park is an economic associate for Kudlow & Co., LLC.