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The Economic Effects of Recent Increases in Energy Prices

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The Economic Effects of Recent Increases in Energy Prices CONGRESS OF THE UNITED STATES CONGRESSIONAL BUDGET OFFICE The Economic Effects of Recent Increases in Energy Prices U.S. Spending on Petroleum as a Percentage of Gross Domestic Product 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005 JULY 2006 Pub. No. 2835 A CBO PAPER The Economic Effects of Recent Increases in Energy Prices July 2006 The Congress of the United States O Congressional Budget Office Notes Unless otherwise indicated, all years referred to in this report are calendar years. Many of the figures in the paper use shaded vertical bars to indicate periods of recession. A recession extends from the peak of a business cycle to its trough. Preface Since late 2003, the price of crude oil has doubled, and prices for gasoline and natural gas have also risen significantly. What impact have those increases had on the U.S. economy? This Congressional Budget Office (CBO) paper—prepared at the request of the Chairman of the Senate Budget Committee—analyzes the short-term macroeconomic effects of the recent rise in energy prices as well as the likely effects over the next 10 years. The paper also evaluates the reasons that those effects have been smaller than might be expected on the basis of the U.S. economy’s response to the oil price shocks of the 1970s. In keeping with CBO’s mandate to provide objective, impartial analysis, this report makes no recommendations. John Peterson of CBO’s Macroeconomic Analysis Division wrote the paper—with assistance from Richard Farmer, Mark Lasky, Angelo Mascaro, and Adam Weber—under the super- vision of Robert Dennis. Bob Arnold, Douglas Hamilton, Arlene Holen, Joseph Kile, Kim Kowalewski, David Moore, and Thomas Woodward of CBO provided helpful comments, as did James Hamilton of the University of California at San Diego and Ellen Hughes- Cromwick of the Ford Motor Company. (The assistance of external participants implies no responsibility for the final product, which rests solely with CBO.) Christian Howlett edited the paper, and Christine Bogusz proofread it. Adam Weber pro- duced the figures. Maureen Costantino designed the cover and prepared the paper for publi- cation. Lenny Skutnik produced the printed copies, and Simone Thomas prepared the electronic version for CBO’s Web site (www.cbo.gov). Donald B. Marron Acting Director July 2006 Contents Summary vii Developments in Oil and Natural Gas Markets Since 2003 1 Increases in Demand 1 1 Restrictions on Supply 1 Price Expectations for Oil 3 The Economic Effects of Higher Oil and Natural Gas Prices 5 The Short-Term Impact of Price Rises During the 2 2004–2006 Period 5 The Impact of the Recent Energy Price Increases over the Next Ten Years 10 Why Have the Negative Effects of Recent Energy Price Increases Been Smaller Than Those in the 1970s? 15 3 Immediate Effects on Demand and on Production Costs 15 Monetary Policy 20 The Flexibility of the Economy 22 VI THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES Figures 1-1. Prices for Crude Oil and Natural Gas 2 1-2. Annual Change in Petroleum Consumption in Selected Regions, 2003 to 2005 3 2-1. Households’ Spending on Energy as a Percentage of Disposable Personal Income, 1965 to the First Quarter of 2006 8 2-2. Households’ Real Spending on and the Relative Price of Motor Fuel and Fuel Oil, 1970 to the First Quarter of 2006 8 2-3. Personal Saving Rate, 1965 to the First Quarter of 2006 9 2-4. Hourly Compensation, 1985 to the First Quarter of 2006 9 2-5. Measures of Capital Income, 1965 to the First Quarter of 2006 10 2-6. The U.S. Trade Balance and Petroleum Imports, 1965 to the First Quarter of 2006 11 3-1. Comparison of the Price of Crude Oil, Consumer Price Inflation, and GDP Growth, 1965 to the First Quarter of 2006 16 3-2. Consumer Confidence, 1965 to June 2006 17 3-3. Comparison of Energy Price Shocks 18 3-4. Business Fixed Investment, 1965 to the First Quarter of 2006 19 3-5. Real GDP of Foreign Economies, 1971 to the First Quarter of 2006 19 3-6. Real U.S. Exports, 1970 to the First Quarter of 2006 20 3-7. Energy Consumption and Gross Domestic Product 21 3-8. Single-Family Housing Starts, 1965 to the First Quarter of 2006 24 Summary Contrary to general expectations, the large and a quarter of a percentage point in 2004 and by less than persistent rise in energy prices that has occurred over the half a percentage point in 2005; so far this year, the re- past two and a half years has not caused substantial prob- duction has been about a quarter of a percentage point. lems for the overall U.S. economy. Although many Therefore, GDP in 2006 is probably lower by about households have had trouble adjusting to the higher 1 percent than it would have been if energy prices had prices, the effects on the nation’s gross domestic product not risen. (GDP), employment, and inflation have thus far been moderate. The reasons for that outcome include various In addition, the rise in energy prices added more than a interrelated factors—for example, the U.S. and many for- percentage point to consumer price inflation in 2005, 1 eign economies were at robust points in the business cycle pushing it to 3 percent. With energy prices excluded, when energy prices began to rise, the Federal Reserve has however, consumer price inflation appears to have been built up a legacy of successful monetary policy, and the only slightly higher than it would have been otherwise. If U.S. economy has changed over the past 25 years in ways energy prices do not increase further and if monetary pol- that have increased its underlying flexibility and stability. icy remains moderately restrictive, the rate of inflation is likely to fall back to about 2 percent a year by the end of 2007. Recent Developments in Energy Prices Since late 2003, the price of crude oil has doubled, natu- Households’ income and spending were both affected by ral gas prices have temporarily hit new highs, and prices the rise in energy prices. The growth of real hourly com- for coal and electricity have risen steadily. The most im- pensation slowed (the result of a slowdown in nominal portant of those increases, in terms of their effects, has wage growth combined with the increase in inflation). At been the rise in the price of crude oil. the same time, the average household’s annual spending on energy goods and services rose by about $1,700 be- The consensus view as of July 2006 is that most of the in- tween 2003 and mid-2006, and their saving rate dropped crease in the price of oil will persist. That price may fall sharply. The fall in the saving rate helped dampen the below its recent level of more than $70 a barrel, but be- negative effects that higher prices would ordinarily have cause the increase stemmed largely from growth in the had on the economy in the short run. If households try to demand for oil rather than from a temporary reduction in rebuild their savings, however, consumer spending may the supply, market analysts do not expect the price of oil be diminished slightly over the next few years. to be significantly lower, on average, over the next 10 years. (In early 2004, by comparison, analysts expected Overall, corporations were less affected by the rise in en- the price of oil to be on the order of $30 a barrel for the ergy prices than households were. The profits of non- following 10 years.) energy-producing firms grew less rapidly than they would have in the absence of the energy price hike, but corpo- rate profits overall increased. Much of that rise reflected a The Economic Impact of Higher Prices continuation of previous trends, as companies continued The recent increases in energy prices have dampened eco- nomic growth in the United States. The growth of real 1. In this paper, “consumer prices” refers to the personal consump- (inflation-adjusted) GDP was probably reduced by about tion price index unless otherwise noted. VIII THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES to reduce debt-service costs and depreciation expenses change in the “terms of trade” will affect the standard of grew slowly. In addition, of course, the profits of energy- living in the United States for many years. producing companies increased sharply. Most energy- using industries were apparently able either to pass on the higher costs of energy to their customers or to compen- Changes in the Economy’s Response sate for those costs through slower growth in other pro- Since the 1970s duction costs. Largely because the demand for goods and The nation’s experience with oil price increases in the services remained strong, the level of businesses’ invest- 1970s led many people to believe that such increases ment spending on structures and equipment, which be- would lead to sharp slowdowns in economic growth and gan increasing in 2003, continued to be high in recent persistently higher inflation. The absence of such severe years despite rising energy prices. effects in recent years has thus been surprising. GDP is expected to largely rebound from its short-term Many of the problems associated with the oil price shocks losses, although the shift in energy prices is likely to keep of the 1970s, however, were unique to that period. The the level of GDP over the next 10 years lower than it U.S.
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