Do Oil Price Moves Signal Trouble Ahead for the U.S. Economy?

oil rigs
oil rigs

Crude oil futures traded below $80 a barrel Monday for the first time since the beginning of March, with many analysts attributing the sell-off to concerns about the health of the global economy. But do those analysts have the relationship between energy prices and the economy the right way around?

It has long been known that higher costs for gasoline, for example, can have an adverse effect on growth. The reason is that while rising prices at the pump may deter some buyers from filling their tanks, the demand for gasoline tends to be somewhat inelastic. In other words, many people must buy gas -- to get to work, for example -- unless prices reach the point where it becomes totally unaffordable.

Under the circumstances, some of the money that might have been spent on, say, new clothes, a night on the town, or an item of furniture ends up in the coffers of oil producers, most of which are based outside our borders. But is there a way to quantify this effect? Some have pointed to the absolute price level, suggesting that $80 a barrel oil, for instance, is the trigger for a slowing economy. But those same arguments were made when oil was trading at various price-points through the years, and don't take into account of the fact that individuals and businesses tend to adjust to structural (long-term) shifts in prices.

A more relevant measurement may be how quickly prices rise and fall. In fact, a comparison of past oil price swings and changes in U.S. real (i.e., inflation-adjusted) gross domestic product reveals an interesting relationship.

As the following chart illustrates, if you overlay the inverse of the 12-month rate-of-change in oil prices, shifted forward by 18 months, on the year-over-year trend in real gross domestic product, the two graphs loosely track one another.

In other words, a sustained and significant short-term increase in the price of oil has been associated with an eventual downturn in the U.S. economy, and vice versa.

So what is the trend of the past year and a half or so telling us about the economic outlook for the period ahead? Well, if the relationship continues to behave as it has in the past, the economy will come under pressure during the second half of this year.

Of course, as any statistician worth his or her salt will tell you, correlation is not the same as causation. What's more, given everything that has taken place over the past few years, including massive government intervention in the economy, there may be good reason to believe this time will be different.

Then again, maybe not.

Originally published