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Pump Price Pinch -- IHS Global Insight Perspective on Causes, Effects and Economic Impacts of Rising Gasoline Prices

(03/06/2012)

Pump Price Pinch: Déjà vu all over again!

The pump price pinch is starting to be felt all over again. Pump prices are breaking records in the New Year with the highest January and February monthly averages on record. The big driver – jitters over Iran.

Consumer Mood and Pump Price Pinch

Increased anxiety about a potential disruption to supply has pushed up world oil prices, as tensions between Iran and the West have mounted over Iran's nuclear ambitions. Higher oil prices mean higher gasoline prices at the pump.

When pump prices jump, households have little choice but to pay the additional charge to fill up their tanks. Many consumers must dip into their savings, or make use of their credit cards, and spend less on more discretionary items. In addition, the psychology of watching the tick-by-tick increases in the bill at the pump is extremely important in understanding consumer behavior and attitudes.

Americans spend less than 4% of their personal disposable income on gasoline (3.3% in January), but gasoline prices tend to play a major role in defining consumer confidence, and inflation expectations.

IHS Global Insight's econometric analysis of the Reuters/University of Michigan Consumer Sentiment and the Conference Board Consumer Confidence indices shows that a higher unemployment rate, higher initial unemployment insurance claims, and higher gasoline prices have a negative effect on consumer sentiment and confidence. On the other hand, rising income, better job prospects, and increasing stock prices have a positive influence on the consumer mood. While it is extremely difficult to isolate a particular cause for month-to-month movements in consumer sentiment and confidence, we can identify those factors and their magnitudes which do seem to systematically affect the consumer mood and outlook in relation to gasoline prices.

Rising and Falling Gasoline Price Effect: A 10% rise in the gasoline price relative to the overall price level reduces consumer confidence by 1.4% to 1.5%. A 10% fall in the relative price of gasoline will increase consumer confidence by the same amount.
Gasoline Price Trigger Effect: When rising gasoline prices approach and surpass round dollar values – $3.00 or $4.00/gallon, for example – there is a sudden jolt downwards of 1.4% for consumer sentiment, and 3.79% for consumer confidence. Interestingly, when declining gasoline prices dip below a round dollar figure, there is no noticeable increase in consumer confidence or sentiment.
Inflation Expectations Effect: Rising or falling gasoline prices have a large influence on where consumers think prices will be one-year ahead, despite the relatively small weight of gasoline prices in the headline CPI (Consumer Price Index) of approximately 5%.
Consumers Focus On the Actual Price: Consumers are psychologically and behaviorally impacted by the actual price of gasoline, rather than the "seasonally adjusted" price that shows up in the CPI or real income statistics.

Even though gasoline prices have been on the rise since the latter half of December, there has been some relatively good news on other consumer and business fronts. The unemployment rate has dropped considerably in the last six months, initial claims for unemployment benefits are at the lowest level since March 2008, and the equity markets have been generally rising and have not been volatile. All of these factors have a statistically positive impact on the consumer mood that currently outweighs the recent rise in gasoline prices.

The recent news on the economy, other than rising gasoline prices, has also been boosting President Obama's reelection chances. However, given the current levels of world oil prices, we expect that the nationwide average gasoline price will surpass $4/gallon before Memorial Day. This is clearly a potential negative for households, the US economy as a whole, and the President – but how much damage would it mean?

Impact on the US Economy

As we have seen, higher gasoline prices have important effects on consumer psyche and personal spending at the microeconomic level. In an attempt to shed more light on the effects of higher oil and gasoline prices on the broader US economy, we review IHS Global Insight's model-based rules of thumb for oil price impacts. These rules not only reflect the direct effects on consumers of higher gasoline prices, but also filter through higher petroleum costs to other prices. In addition, they factor in multiplier effects—i.e., if consumers cut spending because gasoline prices are higher, that will reduce somebody else's income and, in turn, reduce their spending.

In particular, let's consider the impact of a permanent $10/barrel increase in the price of crude oil – which corresponds to a 24-cents increase in the average national gasoline price per gallon.

Rules of Thumb: Effects of a $10/barrel Rise in Crude Oil Prices

Our February forecast for 2012 US GDP growth (2.1%) was based on a $115/barrel average price for Brent oil for the year. Given the recent escalation in tensions, we now think it more likely that the price will average around $121 for the year – running above that in the immediate future, but then gradually easing over the rest of the year on the assumption of some relaxation in tensions and some destruction of demand caused by the higher prices.

Based on our rules of thumb, an extra $6 on the price of oil would only take around 0.1% off the growth rate this year. Even if the price were to hold at the present $125 market price for Brent, the growth hit is only 0.2%. Of course, any drag on growth is undesirable in the context of an already slow recovery. And the potential damaging "threshold" effects from hitting $4/gallon in the second quarter could temporarily amplify the hit to growth.

But the bad news from oil and gasoline prices is not yet bad enough to drive the economy back into recession – and it has probably been outweighed by the stream of other good news, for example, from the labor market and from auto sales.

In the event of a real disruption to supplies – one bad enough to kick the Brent oil price up a further $30-$40/barrel, meaning gasoline prices hitting $5/gallon rather than $4/gallon– we would be staring recession in the face. But we are not near that point now.

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