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A news story that
compares the rising price of oil to the rate of inflation made the
rounds of American media last month. Reporters, pundits and some
economists repeated the parable without giving it much thought. The
essential claim is that in 2005, higher oil prices will not drive up the
rate of inflation as much as they did in the 1970s because oil
consumption, as a percentage of GDP, has decreased by half since then.
We have become much more efficient in our use of oil, claim the
analysts, and therefore higher oil prices will only have a modest upward
impact on inflation.
Rubbish.
Although
the statement is true, the concept masks a lot of dirty little problems.
Here
is why.
Economics
The
historical relationship between the price of oil and the rate of
inflation gives us clues as to what we may expect in the future. In
1974, the price of oil on the world market increased by 252 percent,
from an average of $3.29 per barrel in 1973 to $11.58 per barrel in
1974. Inflation (CPI-U) rose sharply, from an average of 6.23 percent in
1973 to 10.97 percent in 1974, and remained high at 9.14 percent in
1975. In 1979, oil again made a dramatic 121 percent jump in price as it
moved from $13.60 in 1978 to $30.03 in 1979. It gained another 19
percent in 1980. Despite the fact that Americans had become more
efficient in their use of oil since the price increase of 1974,
inflation also increased, by a chaotic 11.26 percent in 1979, 13.52
percent in 1980, and 10.37 percent in 1981. One could argue that
conservation had not done anything to slow down the inflationary spiral.
By contrast, a 48 percent decrease in the price of oil in 1986 was
accompanied by only a modest decrease in the rate of inflation from 3.57
percent in 1985 to of 1.92 percent in 1986. Given the percentage
decrease we experienced in the price of oil in 1986, the rate of
inflation remained stubbornly buoyant.
If
we generate a chart that shows the average annual nominal price of oil
versus the average annual rate of inflation for the period 1970 through
2002, we can see by inspection there is a modest correlation
between changes in the price of oil and concurrent or subsequent rates
of inflation. We have to remember, however, that the rate of inflation
is influenced by many other economic factors: the level of current
economic activity, speculation in the commodity markets, interest rates,
changes in productivity, and so on. None-the-less, history suggests that
if the price of oil effectively doubles, there has to be an increase in
the rate of inflation.
In
doing the research for my book "Oil, Jihad and Destiny" I
developed a formulae to replicate historical changes in the annual
average price of oil versus corresponding changes in the rate of
inflation from 1970 through 2002. I discovered that the formulae's
accuracy was greatly improved if it also included the annual increase in
oil consumption efficiency. Unfortunately, the model can only project
the rate of inflation based on changes in supply and consumption. It
cannot account for futures speculation or changes in the value of the
dollar. Never-the-less, if we use the formulae to project future
rates of inflation versus projected increases in the price of oil, we
must conclude that even with liberal assumptions about the rate at which
we increase the efficiency of oil consumption, the rate of inflation is
going to accelerate.
When
the Federal Reserve increased the fed funds rate to 2.75% on March 22,
2005, it noted that "pressures on inflation
have picked up in recent months." With the computer modeling
tools at its disposal, its extensive information resources, and its
staff of very bright people, the Federal Reserve must certainly be aware
of the relationship between the price of oil and its inflationary impact
on economic activity. The Fed knows that its previous policy of easy
money has sown the seeds of increased inflation. In addition, Federal
Reserve Chairman Greenspan has already warned that America's heavy
burden of public and private debt, as well as the cost of sustaining a
presence in Iraq, homeland security, Social security, and Medicare are a
troubling financial burden. The Fed is very much aware that these
factors taken in the aggregate - create an inflationary economic
environment. Even with computer models and bright people, however, it is
still difficult for the Fed to judge the timing of future
inflation.
Unequal Distribution
There
are gut wrenching reasons to fear the inflationary pressures of
increased oil prices. Take the Law of Unequal Distribution. This law
states there will be an unequal distribution of economic change among
the economy's participants. We can classify these participants by
various measures in order to make a comparison.
For
example, increased oil prices will have only a marginal impact on
organizations that use relatively little oil in the provision of goods
and services. We can anticipate financial service, insurance, health
care, education, government, and utility enterprises will experience
little or no cost inflation as the price of oil increases. On the other
hand depending on their business model - transportation, retail,
wholesale, agriculture, construction, and manufacturing enterprises may
experience modest to sharply increased cost inflation. These costs, less
gains in oil consumption efficiency and changes to the basic business
model, will eventually have to be passed on to the ultimate consumer.
The
Law of Unequal Distribution will be especially hard on consumers. I
fired up my trusty spread sheet in order to determine how rising fuel
costs would impact the finances of households making $25, $50, $100,
$200, and $275 thousand dollars per year. Assuming one car per household
that gets 18 MPG, and 10,000 miles of driving per year, each household
consumes 555.6 gallons of fuel per year. Last year that fuel could be
had for $1.44 per gallon. On average, households in this scenario would
have spent .33 percent of
their income on vehicle fuel. With gasoline prices moving up to $2.88
per gallon, the average household expenditure increases to .66
percent of income.
The
trouble as stated in the first paragraph of this article is in
the averages. The percentage change in vehicle fuel costs are relatively
easy to absorb if your making $100, $200 or $275,000 per year.
Households with $275,000 in annual income, for example, would only spend
.58% of their income on vehicle fuel. However, lower income
households take a terrific hit. Households with $25,000 in annual income
would be forced to spend 6.4 % of that income on vehicle fuel. For
households that make $50,000, their vehicle fuel costs would jump to
3.2% of their annual income. And it's important to note that these two
groups, taken together, account for 56 percent of American households.
Obviously, increases in the price of oil will have a serious impact on
the available discretionary spending of the two lower income groups.
I
then developed a second model, making suitable adjustments for the
probable average mileage per vehicle (assuming wealthy households would
retain their 15 and 18 MPG vehicles while lower income households
migrated to vehicles getting 22, 27 and 33 MPG). If the price of vehicle
fuel is $2.88 per gallon, the average
percentage of household income spent on vehicle fuels would only be .42 percent of income. That's the kind of figure the media likes to
quote in its "sound bite" news broadcasts. The average
expenditure doesn't appear to be too bad. But unfortunately for a
household having an annual income of $25,000, the cost of vehicle fuel
actually increased from 1.75% of income in 2003 to 3.49 % of income in
2005. That's over $870 ! And households with an income of $50,000 will
have to spend over $1,000 on vehicle fuel.
And
how about the guy who wants to keep his beloved pickup truck that gets
15 MPG? If his household is in the $25,000 bracket, he'll have to pony
up almost 8 percent of his household income for vehicle fuel.
Sorry.
But
vehicle fuels are only part of the inflation story. These 112,000,000
households also heat their homes and buy other products made where oil
is either consumed as a raw material or used in the production process.
The big nut is heating oil and its natural gas equivalent, followed by
oil intensive products (fertilizers, chemicals, lubricants, and so on)
and products whose manufacture uses relatively small amounts of oil.
Taken in the aggregate, America's economy consumes 3,450 gallons (or
82.1 barrels) of oil per year per household.
Non
vehicle oil costs probably add over $1,000 (or 4 percent) per year to
the budget of a household making $25,000 per year. They will add over
$1,800 (but less than 1 percent) to the budget of a household making
$275,000 per year. For households making $50, $100, and $200,000 per
year, the percentages are 3, 1.5, and less than 1 percent, respectively.
The
bottom line. If we add the annual cost of vehicle fuel oil consumption
to the cost of non vehicle oil consumption, and if oil prices hold at
the levels experienced during the first quarter of 2005, then American
households on average will spend just over one percent of their
income on oil. That's the figure we will see in the media. It's the same
logic described in the first paragraph of this article. But for
households making $25,000 per year, that number jumps to more than 8
percent of their annual income, and it's almost 6 percent for households
in the $50,000 income bracket. The Law of Unequal Distribution shows us
that at these prices, households in the lower two income groups (56% of
American households) will be forced to make serious adjustments to their
spending habits.
The Impact
Still
think oil price increases aren't inflationary?
Well,
here is another reality. Any claim that an increase in the price of oil
will not drive up inflation is based on the implicit assumption there is
no shortage of oil. Bad assumption. Shortages are coming. Competition
for available fuel will drive up the price (as it has already done in
1974 and 1979). For manufacturers and retailers, supply chain and
distribution costs will increase faster than other business costs.
Transportation links will be less reliable and more expensive. Suppliers
of both goods and services will be forced to develop business models
that use less transportation. Logistics productivity will decrease.
It's
all inflationary.
For
a country like the United States, there will be an outsized impact. This
economy, and the business models of its individual enterprises, has been
built on the assumption of readily available and low cost fuel. Both
assumptions are now false. Depletion induced oil shortages will occur.
Higher fuel prices are inevitable. Decreasing transportation flexibility
translates into higher production and distribution costs. Just-in-time
delivery will gradually migrate to local warehousing operations.
Production will move closer to the consumer. Inventory costs will
increase. Retail consumer traffic patterns and buying habits will
change. Food costs will go up. The list of probable change is very long.
Oil dependent enterprises will be forced to make significant changes to
their business model
or perish.
But
the real change will be at the consumer level in the chain of
distribution.
Productivity
will decline. That drives up inflation. In an effort to drive down their
costs, suppliers will attempt to accelerate their use of computer based
inventory management systems and the Internet for consumer distribution.
On-line transactions can be tracked in order to tighten the distribution
channel and reduce the need for excess inventory. Consumers will be
encouraged to make their purchases from the suppliers WEB site, rather
than drive to the store. Home delivery services will proliferate.
Companies such as Wal-Mart, Federal Express, Ford, and McDonalds will be
forced to make a fundamental change to their business models.
Unfortunately,
there is a limitation to the substitution of on-line transactions for
in-person shopping and distribution. Because the Internet suffers from
the imbedded faults of an inadequate architecture, defective software,
and a deficient network, America lacks the communications infrastructure
to fully substitute on-line interaction for travel. Why? Congress has
thus far failed to establish a credible communications policy. Our
representatives refuse to recognize the realities of the economic and
cultural challenges that face us.
Too
bad. If Congress was on the ball, we could avoid a lot of headaches.
Based
on an average annual price of $41 per barrel, my model projects that the
year-over-year change in the consumer price index (CPI-U) for 2005 will
be a modest 3.1% because deflationary pressures are also working their
way through our economy. Higher interest rates, a decrease in the rate
of economic growth, and our policy of exporting jobs in exchange for low
cost goods and services all tend to retard inflation. If oil continues
to sell for more than $50 per barrel, however, the rate of inflation
will be higher and the Fed will be forced to accelerate its pace of
interest rate increases. (Please note: the economic impact of oil
production, consumption and pricing on inflation, unemployment and GDP
is detailed in my book "Oil, Jihad and Destiny").
Speculation
and shortages will push up the price of oil. Speculation and surpluses
will drive the price down. But the impact of oil depletion guarantees
that the long term price trend is UP. Obviously something has to give.
The consumer will have to make choices. Shoes for the kids or gasoline
for the car? Meat on the table or fuel for heat? Make an impulse
purchase at Wal-Mart or pay the rent? It's going to be rough. Tight
spending control for two thirds of American households.
Or
go broke.
They
aren't going to be happy.
And
a final note. The model I developed for the American economy can be
applied with some revision of the assumptions to the economy of
any industrialized nation. Japan, France, Australia, South Korea it
doesn't matter.
Inflation
knows no borders. It will be everywhere.
ฉ
2005 Ronald R. Cooke
The Cultural
Economist
Author, "Oil, Jihad &
Destiny" and "Detensive Nation"
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