Politics & Policy

The Growth-Driven Oil-Price Increase

Not an economy choker.

By Victor A. Canto and Samir Ghia

The surge in oil prices has managed to grab the market’s attention. Some analysts worry that higher oil prices, acting like a new tax on the economy, could choke the recovery and drive us into recession. But the correlation between oil prices and the economy depends on the nature of the oil shock. And in a way, this oil shock is good natured.

Implicitly, some analysts assume that today’s higher oil prices are the result of a supply shock. In theory, a reduction in supply leads to a movement along the demand curve that results in a higher price and lower output. However, a shift in supply is not the only source of a commodity-price increase. A demand shift can also produce a higher price, yet the effect on output is very different.

Over the last few quarters, there has been a positive correlation between the rise in oil prices and real growth of gross domestic product in the U.S. The timing of the surge between the two is quite telling. It suggests that the oil-price hike is demand driven — which leads to a much different conclusion than the one worried analysts are making.

Backing up this argument is the broader correlation between real GDP growth and the growth of commodities overall. For a while now both have been spiking higher, lending further support to the view that the oil-price increase is growth driven.

And who are the culprits in this growth-driven oil spike? In large part, the U.S., China, and India are to blame, even though each is benefiting from the current set of economic circumstances.

The rise in oil prices will produce several outcomes. It will increase the incentives to produce more energy — from oil-related or alternative sources — while also crowding out slower-growing countries from the energy markets. For the slow-growers, demand is not growing as fast, and higher energy prices will have a negative impact on their real GDP growth rate. Countries like Japan are among those at risk. Not surprisingly, such economies have not fared well in the high-energy-price, high-commodity-price environment.

Last year the financial press spoke of a $10 terrorist risk premium imbedded in the price of oil. Judging from the Iraqi election results and other positive changes taking place in the Middle East, one can argue that the world has become a safer place. If the terrorist risk premium were the true source of the oil-price increase we would be seeing lower, not higher, prices.

No — today’s rising oil prices are the result of global economic expansion. This is good news: Rising oil prices caused by an increase in demand cannot cause a recession. In fact the opposite is quite true: A recession would lead to lower oil prices.

The Federal Reserve and inflation worriers in general should take note of all this. Inflation is too much money chasing too few goods, and higher growth produces lower inflation, not higher inflation. Hence, the growth-driven oil-price increase will lead to a boost in supply and eventually lower oil prices.

– Victor Canto, Ph.D., is the founder and Samir Ghia a vice president of La Jolla Economics, an economics research and consulting firm in La Jolla, California.

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