A tight oil market and potential spillover from geopolitical competition has unnerved investors over the past few months, sending oil prices to elevated levels not observed in years.
The price of oil has almost doubled since the start of last year and, given current tensions, is poised to move higher. The potential for a broader energy shock to the global and U.S. economies should Russia invade Ukraine has added to a combustible mix of factors that is causing inflation to accelerate in the United States and abroad. That risk carries with it the potential to slow down growth.
If there is a European war, we would expect a 20% increase in the price of oil, sending it to roughly $110 per barrel. Together with the spillover effect on natural gas prices, consumer confidence and uncertainty, the conflict would shave a little less than 1% from gross domestic product over the next year and cause inflation to rise by close to 2.8 percentage points to over 10%.
The burden of adjustment under such conditions would be borne by American households and firms that would face a sudden shock to discretionary income.
This, of course, would put the Federal Reserve in a bind: It would need to move aggressively in the near term to boost interest rates at the expense of tightening financial conditions. That, in turn, would hurt equity prices, creating conditions for a negative wealth effect among households.
Underscoring our shock model is an assumption that the movement in energy prices would be temporary and would fade quickly once hostilities end. Should that not be the case, then we would revisit the impact of the shock on inflation, growth and the duration of the current economic expansion.
The meaning of $100 oil
Our base case is consistent with a greater-than-two-standard-deviation shock to consumer confidence and would work through the household channel and dampen overall investment by the corporate sector.
Both have been key drivers of growth during the recent increase in prices. It would directly translate into rising energy prices, higher borrowing costs and an increase in the overall cost of doing business.
For some, this may seem counterintuitive. How could that type of shock only result in a little less than a 1% drag on growth? That has to do with the combination of diversification away from oil, the use of natural gas to heat homes, the development of alternative sources of energy, the changing composition of demand—think of the growing electric vehicle fleet—and the near self-sufficiency of the United States for its energy.
The U.S. economy is far less sensitive to movements in the price of oil than it was 20 years ago.
Put simply, the U.S. economy is far less sensitive to movements in the price of oil than it was 20 years ago.
Perhaps the best way for a policymaker, investor or midsize business owner to think about this is that each increase of $10 in the price per barrel of oil shaves 0.15% off of GDP over the intervening 12 months. This is down from the 0.3% that occurred before the fracking revolution.
Ironically, the same type of shock to domestic natural gas prices would create a larger drag on the U.S. economy, which is indicative of the broader energy transformation underway.
The fixation on $100 per barrel of oil is somewhat misguided in our estimation and has little meaning other than in the psyche of the financial press and public.
Diversification away from overdependence on oil has pushed up the price of oil where recession risks for the U.S. economy become paramount. That would appear to be north of $130 per barrel given the diversification dynamics at play. In our shock model, it is the move above $130 where the duration of the current business cycle is at risk.
We subjected growth and inflation to a 10%, 20% and 40% shock to the price of oil and natural gas to ascertain the impact on the economy.
The American economy is well positioned to withstand a 10% shock to the price of oil, albeit with a noticeable increase in inflation over the following year. A shock to natural gas markets yields similar results with only a modest increase in inflation.
The alternative 40% increase in oil prices, which gets us to that $130 per barrel or above range, would subtract 1.5 percentage points from U.S. growth over the next year and push inflation well into double-digit year-over-year growth during that time.
Once that $130 per barrel threshold is breached, then it would be appropriate for the fiscal and monetary authorities to begin considering downside risk and policy alternatives to bolster the overall economy.
The condition of the American economy is far more durable and resilient than currently acknowledged. Despite the increase in the domestic price of oil from $48.52 at the beginning of last year to over $90 per barrel today, the economy has staged an impressive recovery. The current obsession over $100 per barrel of oil seems outdated and somewhat misguided.
What is perhaps more important are the geopolitical dynamics at play that carry exogenous risk to the economy and financial markets. Our base case is that even a 20% increase in the price of oil from current volatile levels will not derail the current business expansion.
But the burden of adjustment through higher prices and the cost of doing business will fall squarely on the shoulders of the American middle and working classes, as well as the commercial sector.