Financial Perspectives – Summer 2008

A Bigger Bite From Higher Energy Costs

Timely Commentary from Raymond James
Chief Economist Scott Brown

The U.S. economy has faced three important stumbling blocks this year: the ongoing housing correction, the credit market crisis and high energy costs. A sharper drop in home prices has exacerbated the housing downturn, but lower prices help to improve affordability, which should eventually lead to a bottom in the housing sector. The credit crisis grew more frightening into early March, but conditions have improved following the collapse of Bear Stearns. The major New York banks have recapitalized. Credit market conditions are still far from normal, but the demand for liquidity has relaxed. The risks of a more substantial housing correction and financial market melt-down have receded. However, the price of crude oil has continued to rise, boosting overall inflation, dampening consumer spending growth and squeezing corporate profits.

The cause of the increase in the price of oil and other commodities is not entirely clear. Rising global demand has been a factor. The softer dollar has played a part. Increased speculation may also have been at play. The futures market has continued to suggest an expected moderation, but the futures have done a poor job in projecting oil prices over the last few years.

The increase in food and energy prices has added to inflation concerns. Data through May showed pipeline pressures working through to the wholesale level, but – outside of food and energy – not affecting much at the consumer level. Firms still have a limited ability to pass along higher costs since softer overall growth makes it harder to raise prices. Meanwhile, profit margins had expanded in the last several years, providing some cushion against higher inflation.

Most important, for the Federal Reserve, there’s been little sign of inflation pressure from the labor market. However, pass-through effects of higher energy costs may simply be a matter of time.

Still, higher food and energy costs, particularly gasoline prices, are a major restraint for the consumer. The impact of higher gasoline prices falls unevenly across the income scale. In most major metropolitan areas, people often live far from where they work (since homes are less expensive the farther out you go). These households are now hit with both rising commuting costs and reductions in home equity.

Yet, the strain of higher gasoline prices is not unique to low- and middle-income households. Anecdotal reports suggest a broad slowing in consumer spending growth across the income scale into the late spring. People may continue to eat at restaurants, but they’re more likely to scale down. The “staycation” – spending time at home rather than traveling – is expected to be a common theme this summer.

Over time, consumer spending patterns will adjust to higher gasoline prices. Consumers have already begun shifting to more fuel-efficient vehicles. Wage and salary income will rise, boosting consumer purchasing power. However, consumer spending growth is likely to be subpar in the near term and the economy will be susceptible to even further increases in energy prices, should they occur.

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