Sunday Telegraph columnist Liam Halligan notes that US recessions since the early 1970s have been preceded by a spike in oil prices, defined as a sharp rise of 80% or more. Spot Brent crude has risen from a low of $67.4 per barrel in late May last year to $112.5 on Friday – a 67% gain. The 80% threshold would be reached by a further increase to $121.3. Should investors fear another US – and global – downturn?
A monetarist view is that oil spikes lead to recessions because they raise the general level of prices, thereby deflating real money balances, with monetary contraction in turn causing consumers and firms to cut spending. The extent of the increase necessary to cause a downturn, therefore, depends on 1) the sensitivity of the general price level to changes in oil costs and 2) the rate of monetary growth when the spike occurs.
The impact of a given oil price increase on consumer budgets has fallen since the 1970s. US consumer outlays on energy goods and services accounted for 5.8% of total spending in the fourth quarter of 2010 versus an average of 7.3% over 1971-80. The current share, however, is up from 4.3% in 2002 – the lowest in annual data extending back to 1929.
The chart shows six-month growth in G7 narrow money and consumer prices (both seasonally adjusted). Monetary expansion has accelerated recently, reflecting US strength – see previous post. Real growth has been slowed by a pick-up in inflation but is still running at a solid pace by historical standards. The current relationship is very different from 2000 and 2007, before the last two US and global recessions, when a combination of slower nominal monetary expansion and rising inflation resulted in a contraction in real money.
The current level of oil prices should cause inflation to rise further but is unlikely to push it above the recent rate of money growth. The completion of US QE2, meanwhile, may keep monetary expansion elevated through mid-year, despite weakness in Euroland (previous post). Against this backdrop, oil prices would probably need to rise by significantly more than Mr Halligan's suggested 80% to create a squeeze on real money balances sufficient to trigger another recession.
Put differently, the risk of a recession depends importantly on whether the oil price spike is due to an actual or feared supply shock or also reflects easy money and strong global demand. The current surge seems partly related to monetary loosening – prices broke out to new post-recession highs soon after the Fed embarked on QE2 last November. This suggests that, relative to prior episodes, there will be a larger boost to inflation and a smaller negative impact on economic activity.
