07 14 BUSINESS-CYCLE CONDITIONS Gas Prices Not a Risk to Growth by Robert Hughes, Senior Research Fellow

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1 7 14 BUSINESS-CYCLE CONDITIONS Gas Prices Not a Risk to Growth by Robert Hughes, Senior Research Fellow Gas prices 15 percent jump in six months may be painful at the pump but is moderate by historical measures and not enough to derail the economic expansion. Geopolitical crises have been a part of the American energy story since the mid-197s. Forty years after the crisis that touched off a severe recession and contributed to a developing inflation spiral, recent global events appear to be pushing energy prices higher again. Fortunately, the increases so far have been moderate by historical standards and are unlikely to derail the five-year-old economic expansion, in our view. The recent rise in energy prices crude oil and gasoline in particular began in November 213. That s the time that normal seasonal demand tends to push prices higher; it s also around the time that protests and violence in the Ukraine appeared to be headed for significant escalation. Between November and May 214, average retail gasoline prices in the U.S. jumped about 15 percent, with crude oil posting a similar rise. Just as tensions in the region began to ease, renewed sectarian fighting inside Iraq began pushing prices higher still. From a slightly longer perspective (the past three and a half years, since the beginning of 211), however, both crude oil prices and gasoline prices have remained range-bound, with crude moving between $8 and $11 per barrel and gasoline fluctuating between $3. and $4. per gallon (Chart 1). True, in general rising energy prices are an unwelcome development CHART 1. ENERGY PRICES HAVE RISEN RECENTLY BUT REMAIN RANGEBOUND Retail gasoline price (all grades, average, dollars per gal., left scale) Crude oil price (dollars per barrel, right scale) Source: Energy Information Administration. aier.org AMERICAN INSTITUTE FOR ECONOMIC RESEARCH 1

2 and viewed as a threat to the health of the economy. However, these increases to date are not great enough to cause consumer spending to retrench significantly, harming the broader economy. ECONOMIC OUTLOOK Our Business-Cycle Conditions indicators pulled back in the latest month, following three consecutive increases. The share of leading indicators that expanded in June dropped to 82 percent, down 8 percentage points from a reading of 9 percent in May. Our cyclical score for the leading indicators, derived from a separate mathematical analysis, rose just one percentage point to 88 from 87 in the prior month. Despite the decline in the leaders diffusion index, both measures still register values well above, suggesting that the economic outlook remains positive, with a very low probability of recession in the coming quarters. Key takeaways from the latest readings of AIER s BCC indicators include: Leading: Among the 12 leading indicators, eight were judged as clearly expanding in June, one was deemed probably expanding, one was considered indeterminate i.e., having no discernable trend and two were clearly contracting. Among those eight indicators that were clearly expanding, six hit new cycle highs: M1 money supply, yield curve index, new orders for core capital goods, index of common stock prices, average workweek in manufacturing, and initial claims for state unemployment insurance (inverted). The ratio of manufacturing and trade sales to inventories and vendor performance were the two indicators that were contracting, while the new housing permits was the one with no discernable trend. Coincident: All six of our coincident indicators continued to expand in June, resulting in a perfect reading for the 3th month in a row, confirming that the U.S. economy continues to expand. Two of these indicators CHART 2. THE INDICATORS AT A GLANCE PERCENTAGE OF AIER LEADERS EXPANDING PERCENTAGE OF AIER COINCIDERS EXPANDING PERCENTAGE OF AIER LAGGERS EXPANDING CYCLICAL SCORE OF AIER LEADERS Source: AIER. also hit new cycle highs: nonagricultural employment and index of industrial production. Lagging: AIER s index of lagging indicators registered a perfect percent reading again in June as four out of four indicators with a trend were clearly expanding, and all four hit new cycle highs. These four indicators are: average duration of unemployment, manufacturing and trade inventories, commercial and industrial loans, and the ratio Shaded bars represent official recessions. A score above indicates expansion BUSINESS-CYCLE CONDITIONS JULY 214

3 of consumer debt to income. The composite of short-term interest rates and change in labor costs per unit of output for manufacturing both were indeterminate last month. In aggregate: Nineteen of our 24 indicators were judged to be clearly expanding or probably expanding last month, with 12 of the expanding 19 hitting new cycle highs. Three indicators were considered to have no discernable trend, while two indicators were clearly contracting. Overall, our three diffusion indexes remained well above percent, pointing to continued economic growth in the months ahead (Chart 2). ENERGY FUNDAMENTALS Stepping back from geopolitical events and normal seasonal patterns, the fundamentals for both crude oil and gasoline indicate prices are likely to remain range-bound. Inventory levels for gasoline are currently 219 million barrels, approximately the 68th percentile of the range since 199. Inventory of crude petroleum, excluding the strategic petroleum reserve, are even more robust at 1.1 billion barrels, or roughly the 92nd percentile of its range since 199 (Chart 3). In addition to the high levels of inventory currently in place, growth of refinery output and crude oil extraction both have accelerated in recent months, to 4.8 percent and 16.1 percent on a year-overyear basis, respectively (Chart 4). IMPACT ON ECONOMY Higher energy prices can redirect consumer spending away CHART 3. GAS AND CRUDE OIL INVENTORIES ARE HEALTHY Gasoline inventories (mil. barrels, left scale) Crude oil inventories (mil. barrels, right scale) Source:Energy Information Administration. CHART 4. US REFINERY OUTPUT AND CRUDE EXTRACTION ARE RISING Source:Federal Reserve. Crude extraction (y/y percent change) Refinery output (y/y percent change) from other goods and services, and to the extent that money flows outside the domestic economy to foreign suppliers, higher energy prices are bad for the growth outlook. In the current environment where U.S. economic growth is already viewed by most analysts as weak, the potential of rising energy prices should not be ignored. However, once again, it s important to put the potential impact in perspective. Since the beginning of 211, the U.S. economy has added 7.6 million new jobs, or about 19, per month. When combined with increases in hours worked and with rising hourly earnings, the total additional wages and salaries added to the economy is about $8 billion, or about $2 billion per month at an annual rate. By contrast, consumer spending on gasoline has increased just $ billion, or about $.6 billion per aier.org AMERICAN INSTITUTE FOR ECONOMIC RESEARCH 3

4 month. So from the perspective of the broader economy, gains in jobs, hours worked, and hourly earnings collectively provide far more impetus to the expansion than the modest gasoline price increases exert drag (Chart 5). For the consumer, the impact of rising gasoline prices may be more psychological than financial. As consumers benefit from better job creation, longer hours, and rising wages, spending on gasoline as a percentage of total personal income declines. In addition, as consumers replace older cars with more fuel efficient vehicles, the share of fuel in household budgets declines, further protecting the economy from fuel price rises. For much of 211, spending on gasoline accounted for about 2.8 percent of total personal income. As of April 214, gasoline expenditures accounted for about 2.5 percent. Likewise, when measured against total consumer spending, gasoline expenditures have fallen from about 3.5 percent of total personal consumption expenditures (PCE) to roughly 3.1 percent as of April. Retailers are usually the group most concerned by the prospect of rising gasoline prices, which divert consumer spending away from other purchases. While the fear is understandable intuitively, there actually is little statistical evidence to support that fear. Since 1992, retail sales excluding gasoline sales and retail sales of gasoline have been positively correlated meaning that retail sales excluding gasoline tend to rise along with rising gasoline sales. Only during some subperiods of extreme gasoline price CHART 5. WAGE AND SALARY GAINS FAR EXCEED GAS EXPENDITURES Change in gasoline expenditures ($bil., inverted) Change in wages & salaries ($bil.) Source: Bureau of Economic Analysis. CHART 6. GASOLINE SALES TEND TO BE POSITIVELY CORRELATED WITH RETAIL SALES Source: Census Bureau. Retail sales of gasoline (y/y percent change, left scale) Totla retail sales ex. gasoline (y/y percent change, right scale) increases have non-gasoline retail sales appeared to suffer (Chart 6). CONCLUSION Rising gas prices are a concern for anyone who fills a gas tank and particularly for anyone who lived through the 197s oil embargo, long lines and rationing at gas stations, spiraling inflation, and recession. Economists and policymakers also are rightly concerned about the potential for a repeat of those events. But so far, our business cycle indicators suggest continued economic growth ahead, and energy fundamentals broadly remain supportive of continued range-bound energy prices. n 4 BUSINESS-CYCLE CONDITIONS JULY 214

5 APPENDIX. PRIMARY LEADING INDICATORS M1 Money Supply (1) (constant dollars, billions) Ratio of Manufacturing and Trade Sales to Inventories (3) Yield Curve Index (1) (cumulative total) Vendor Performance: Slower Deliveries Diffusion Index (2) (%) Index of Manufacturers Supply Prices (2) (%) Index of Common Stock Prices (2) (constant purchasing power) New Orders for Consumer Goods (3) (constant dollars, billions) Average Workweek in Manufacturing (3) (hours) New Orders for Core Capital Goods (4) (constant dollars, billions) Initial Claims for Unemployment Insurance (3) (s, inverted) New Housing Permits (3) (thousands) 3-Month Percent Change in Consumer Debt (4) Sources for all charts on page 5 and 6: Federal Reserve Board, Institute for Supply Management, Census Bureau, Bureau of Economic Analysis, The Conference Board, Standard & Poor s, Department of Labor, Bureau of Labor Statistics/Haver Analytics, AIER. aier.org AMERICAN INSTITUTE FOR ECONOMIC RESEARCH 5

6 APPENDIX. PRIMARY ROUGHLY COINCIDENT INDICATORS Nonagricultural Employment (1)(millions) Manufacturing and Trade Sales (2)(constant dollars, billions) Index of Industrial Production (1)(27 = ) Civilian Employment as a % of the Working-Age Population (2) Personal Income Less Transfer Payments (1)(constant $, billions) Gross Domestic Product (1)(quarterly, constant dollars, billions) APPENDIX. PRIMARY LAGGING INDICATORS Average Duration of Unemployment (2)(weeks, inverted) Ratio of Consumer Debt to Personal Income (1)(percent) Manufacturing and Trade Inventories (1)(constant dollars, billions) % Chg. from a Year Earlier in Mfg. Labor Cost per Unit of Output (2) Commercial and Industrial Loans (1)(constant dollars, billions) Composite of Short-Term Interest Rates (1)(percent) 6 BUSINESS-CYCLE CONDITIONS JULY 214 Business-Cycle Conditions is published by American Institute for Economic Research, a nonprofit, scientific, educational, and charitable or ganization. To contact AIER by mail, write to: American Institute for Economic Research PO Box Great Barrington, MA 123 Call: Facebook: facebook.com/ AmericanInstituteForEconomicResearch Twitter: twitter.com/aier LinkedIn: linkedin.com/company/americaninstitute-for-economic-research For more information or to donate, visit:

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