Rising oil may test U.S. economy's green shoots

WASHINGTON (Reuters) - Swiftly rising oil prices threaten to sap the buying power of U.S. consumers who are essential to ending the longest recession since the Great Depression.

Oil has been on a tear in the last five weeks, rising 48 percent since April 21 to hit a 2009 intraday peak above $65 per barrel on Thursday. Part of that reflects hopes that the global economy is inching out of a deep slump, but it may also have something to do with investors seeking an inflation shield as the U.S. dollar weakens and government spending grows.

While oil is nowhere near last summer’s record high of $147 per barrel, the run-up in prices comes at a fragile time for the U.S. economy and so could prove particularly harmful. Unemployment is at its highest level since 1983 and wages are growing at the slowest rate on record, leaving consumers with a much thinner cushion to absorb rising costs.

“We’re counting on consumers to be the spending that eventually brings us back on track,” said James Hamilton, an economics professor at the University of California, San Diego, who has studied the role that last year’s oil price spike played in triggering the current recession.

Hamilton said oil is not yet expensive enough to cause the same degree of pain it did last year, when gasoline prices exceeded $4 per gallon and squashed consumer spending, but if it continues to increase it could “postpone some of the recovery we’d been hoping for.”

The U.S. Federal Reserve, which is currently more concerned about deflation than inflation, would find itself in a tough spot if oil prices sparked a bout of inflation. Its strongest inflation-fighting medicine is higher interest rates, but that would put an unwelcome drag on economic growth.

Saudi Oil Minister Ali al-Naimi said this week the world economy had strengthened enough to cope with oil at $75 to $80 a barrel. OPEC decided on Thursday to keep output steady.

“The price is good, the market is in good shape, recovery is under way. What else could we want?” Naimi said on Thursday.

Riccardo Barbieri, head of international economics at Banc of America Securities-Merrill Lynch, said a gradual rise to $80 or so per barrel would not be enough to kill off an economic recovery in the second half of the year.

However, a sharper increase could trigger bad flashbacks to 2008. If consumers see gasoline prices rising quickly, they may curb spending for fear of a repeat of last year.

LIQUIDITY GLUT

The most direct way that expensive oil hits consumers is through gasoline prices, which typically go up by roughly 2.4 cents for every dollar that crude oil rises.

The average price per gallon of gasoline has gone up 18 percent over the past five weeks to about $2.44, a seven-month high. But the cost of crude oil has risen much more sharply, suggesting gasoline prices will continue to rise in the coming weeks.

Still, that is a far cry from last year at this time, when gasoline prices were approaching $4 a gallon.

The key difference is that consumers’ finances are in much worse shape now. More than 5 million jobs have been lost in the past year, and the Labor Department’s Employment Cost Index, a broad measure of wages and benefits, posted its smallest increase on record in the first quarter of 2009.

Some of the factors that helped drive up oil prices in 2008 appear to be in play now, which may help explain why oil is rising so sharply before there is conclusive evidence that the end of the global recession is near.

The U.S. dollar has fallen about 7 percent against a basket of currencies since April 21. A weak dollar tends to drive up the price of commodities because they are typically priced in dollars for international trade.

There are also signs that speculative investors are pouring money back into a wide range of commodities, which may reflect concerns about inflation after governments and central banks around the world dumped trillions of dollars into the economy to try to stem the recession.

With all that liquidity sloshing around when the dollar is weakening, Barbieri and some other economists are worried that oil will run up far faster than economic fundamentals might otherwise warrant.

“We think there is potentially a danger phase during which oil prices could post excessive rises, threatening a fragile recovery in the advanced economies,” Barbieri wrote in a note to clients this week.

He said the Federal Reserve would probably have to tolerate higher oil-fueled inflation because it would have no room to raise interest rates while the economy remains weak.

To be sure, a moderate dose of inflation could be a good thing. With the government and households staggering under huge debt piles, inflation would make repayment less painful.

But oil-fed inflation would be the worst of both worlds because it would make goods costlier for consumers and businesses without doing much of anything to increase asset values or ease the debt burden, UCSD’s Hamilton said.

“Inflation that comes in an uneven form, with commodity prices zooming up and wages coming down, is not something that would stimulate the economy,” he said.