Will High Oil Prices Regulate the U.S. Economy?

"In the U.S., the Euro Area and the U.K., the track record of inflation during the past few years has deteriorated to the point that a material loss of credibility may well be imminent for all three central banks involved – the Fed, the ECB and the Bank of England," wrote Willem Buiter in a recent piece published by the Financial Times.

"Not surprisingly, mean inflation expectation one year ahead (according to the University of Michigan survey) now stand at 5.7 percent. Mean inflation expectations 5 to 10 years ahead are 3.5 percent. Loss of credibility in the Fed’s willingness and/or ability to maintain price stability is a fact – not surprising, given the institution’s willingness to cut rates massively and swiftly when the real economy turned down, despite continuing high inflation."

If Mr. Buiter is correct, the Fed is losing the fight against inflation. But that does not necessarily mean that inflation will skyrocket over the coming years, because there are natural mechanisms at work that could slow down inflation. For example, rising oil prices may force U.S. consumers to gradually adapt their behavior and spending.

This has important implications, since such a trend could end up controlling inflation. "At this point, we’re seeing an economy that is experiencing a headwind from the high price of crude, which at the end of the day could act as a natural regulator of the economy," says Craig Peckham at Jefferies. In other words, if the Fed can’t slow down inflation, rising oil prices might do the trick. $200 oil might be necessary to limit demand in a supply-constrained world…

But, unfortunately, historical data suggests that U.S. consumers don’t really change their behavior in the face of oil shocks, undermining oil’s impact as a natural regulator.

"In repeated studies of consumer purchases over the years in the developed world, drivers in the United States consistently rank as the least sensitive to changes in gas prices," says Austan Goolsbee, an economics professor at the University of Chicago Graduate School of Business and a senior research fellow at the American Bar Foundation. "Even when gas gets expensive, we just keep on truckin’. The latest estimates, based on a comprehensive study released in 2002, predict that if prices rose from $3 per gallon to $4 per gallon and stayed there for a year (far greater and longer than the impact of Katrina), purchases of gasoline in the United States would fall only about 5 percent."

There have also been structural changes that force U.S. consumer to keep buying gasoline despite rising prices. "In the last two decades when gasoline was cheap, Americans switched from cars to minivans and SUVs, seriously reducing their gas mileage," explains Goolsbee. "Also, many moved farther from their places of work, to suburbs and then ex-urbs. In the 1990s, the average commute time rose about 15 percent, and the share of people commuting alone rose dramatically to more than three out of every four American workers, according to the 2000 census. As jobs moved out of central cities and into suburbs, car-pooling became more difficult and public transportation often unavailable. Less than 5 percent of the population regularly uses public transportation to get to work now (and even that number includes people taking taxis). In Europe and Japan, people drive less when the cost of gas goes up because they still can. On average, they live closer to their jobs. About 20 percent of Europeans walk or ride their bike to work (more than five times the share in the United States)."

Only a long term spike in oil prices will be able to change consumer habits. Goolsbee argues that a five year window gives people the time to come up with substitutes. "Higher commuting costs over that many years could induce you to buy a smaller car, move closer to work, find a car pool for your kids," he says. By that time, it might be too late to stop inflation from spiralling out of control…