Thursday, February 24, 2011

$100 Oil: Inflationary Omen?

The Lehmann Letter (SM)

With oil at $100 a barrel, can inflation be far behind?

We hope not. No one wants another inflationary surge. But are there credible grounds for optimism?

And, after all, didn't a spike in oil prices send inflation surging twice in the 1970s? Once, when OPEC pushed oil from $3 a barrel to $10 a barrel in 1973, and again when OPEC raised its price from $10 a barrel to $30 a barrel in 1979. The CPI climbed by 12% after the first episode and by 16% after the second. Is that an omen for today?

Probably not. Keep in mind that OPEC piled on in the 1970s. It did not lead the inflationary charge. In 1972-73 and in 1978-79 consumer borrowing and spending rose massively, generating a surge in demand for residential construction, automobiles and everything else. Rapidly rising demand pushed capacity utilization toward 90%, raising costs throughout the economy. Inflation began to rise sharply before OPEC contributed to the spike in prices.

Today's background is very different. Household demand, especially for homes and autos, is stuck in neutral. Consumers have been repairing their balance sheets, and are now only timidly borrowing and spending. Capacity utilization remains below 80%, so rising costs don't threaten. Finally, oil is a less important ingredient in today's economy. So we shouldn't be prematurely alarmed that inflation is about to repeat its 1970s climb.

But we should be afraid of what rising gasoline prices might do to still-fragile household spending. When consumers pay more for fuel, less is available for everything else. Moreover, they know that, and gasoline's bump might cool consumer confidence. That would be too bad, because consumer confidence is only now climbing out of the doldrums.

Let's stay tuned and hope that oil heads south soon.

© 2011 Michael B. Lehmann

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