- The Washington Times - Sunday, September 26, 2004

Rapidly rising energy prices in the last year have been a drag on the economy, but are unlikely to derail the ongoing expansion. However, jobs and output will suffer.

The crude oil cost rise, which has recently edged toward $50 a barrel, hasn’t yet had its full effect on the economy or been fully passed through to general inflation.

To some extent, energy-using companies have absorbed the higher costs by trimming profit margins, but that’s at best a temporary expedient. As expansion continues, continued high oil prices inevitable will result in some if not all of the added cost being passed on, though it may be a year or two before the economy feels the full brunt.

The process has already begun. This year’s second-quarter slowing of economic growth was partly due to higher energy prices, as consumers reacted with spending cutbacks. The outlook is less than encouraging.

Economists predict energy price pressures will ease somewhat in the near term. To some extent, higher oil prices will themselves temper demand. Working in the other direction is the business cycle. Most of the world’s industrialized economies are expanding, which boosts oil consumption. All told, supply and demand forces mean energy prices are unlikely to return to the lower levels of recent years.

The Energy Information Administration (EIA) of the Energy Department predicts next year’s oil prices will average about $11 a barrel more than 2001-2003 average prices. Beyond that, the EIA projects long-term inflation-adjusted world oil prices rising for the next two decades. World oil surplus production capacity is thin, and demand is seen outrunning supply, with the U.S., China, Japan and India the major users.

The oil futures market tells a similar story. Prices are expected to taper off to about $40 a barrel by the end of next year, falling to the $36-$37 range in 2006. Though this is well below current prices, it amounts to about a 60 percent increase over average prices for 2001-2003.

If these predictions prove right — and there’s plenty of room for error — the economy could be dealt a significant blow, particularly if people come to believe high energy prices are permanent. Consumers can be expected to tighten their belts another notch and employers will become more cautious about hiring. Firms will probably try to mitigate the effects of rising energy costs by increasing productivity, which translates to fewer jobs and more intense use of the existing work force. Overall inflation will notch up.

Traditional measures of core inflation, which exclude energy prices, will become obsolete. They are already misleading. A comparison of 12-month percent changes in the total Consumer Price Index and the total index less energy shows a widened gap in the past four months, with the overall index higher by nearly a percentage point.

The U.S. is feeling the pinch more than other oil-consuming countries. We pay higher prices because of the declining value of the dollar relative to other currencies. As the dollar has weakened in the last two years, oil-producing countries have sought to recapture the lost value by raising oil’s dollar price.

If energy prices remain high as expected and begin filtering through the economy, how might the Federal Reserve respond? In the tradeoff between more inflation and fewer jobs, the Fed will likely lean toward restraining prices lest inflation get out of control. The Fed can be expected to raise interest rates more aggressively yet allow prices to rise slightly faster than otherwise to avoid excessive demand restraint. Prices will be higher and employment lower.

As much as a half-point could be shaved off the economic growth later in the expansion, most of which would likely fall on employment. Job growth could slow by a half million a year, or by enough to forestall further declines in unemployment.

Alfred Tella is former Georgetown University research professor of economics.

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