Close to a quarter of the world’s oil supply has been bottled up in the Persian Gulf in the past month. Concerns about the safety of passage through the Strait of Hormuz have also disrupted trade in liquified natural gas and fertilizer used for crops around the world. Market reaction to this has been muted so far. This appears to reflect a consensus that these disruptions will cease or ease significantly within a relatively short period of time. If this assumption turns out to be incorrect, there is potential for much higher energy prices, much larger declines in stock prices, and recessions around the world, including the United States.
Since the end of February, crude oil prices have risen about 50% to more than $100 per barrel. Retail gasoline prices jumped to a national average of $3.07 per gallon during the last week of February to $4.13 per gallon at the end of March. When the March Consumer Price Index is released, it will likely show increased gasoline prices of slightly more than 20%, which would be a monthly record. While these increases are dramatic, they are muted considering the scale of the disruption to supplies.
The increase in oil prices would likely be twice as large if the market believed the disruption would last for several more months. Oil demand is relatively insensitive to price changes. As a result, it would require a very large increase in prices to make up for the interruption of supplies. For example, a 10% drop in global supply (meaning about half of the oil that normally transits the Strait of Hormuz is prevented from reaching markets) would require close to a doubling of crude prices from pre-war levels to align demand. For a month or two, inventories and strategic reserves can provide a buffer. But beyond that, the low elasticity of demand starts to bite and would produce additional price increases. The market seems to be assuming that we will not get to this point. But such a scenario needs to be considered.
Energy and the economy: How high will oil prices soar?
American consumers would lose almost 2% of their purchasing power if prices remained in the $100 to $150 per barrel range for a full year. If they remained high for six months, they would lose about 1% of their annual purchasing power. There are secondary effects that work in different directions. Some work to exacerbate the negative effects on the economy (for example, the uncertainty leading to declines in consumer and business confidence). Others work to mitigate it (for example, higher prices would stimulate domestic exploration and eventually oil production). Given that the secondary effects work in opposing directions, the primary effect via the loss of consumer purchasing power provides a useful back-of-the-envelope estimate of the effects on the economy. Consumers would cut back on discretionary spending on items such as travel and eating out. But they would also dip into their savings. Lower-income households have less of an ability to do this and would experience a proportionally larger drop in consumption.
Under a scenario in which oil prices were in the $100-150 a barrel range for six months, growth would likely slow by close to 1%. This would halve most forecasts for growth in 2026. The Russian invasion of Ukraine in March 2022 produced a shock to oil prices similar to this scenario. However, the U.S. and global economies were in very different places in early 2022. They were in the midst of a period of very rapid growth in the aftermath of COVID. In the year to March 2022, the unemployment rate had dropped by 2.4%. In contrast, this oil shock comes at a time of modest growth with the unemployment rate rising slightly over the past year. Moreover, core inflation was much higher in 2022 than it is now.
The economy’s weaker momentum and lower core inflation suggests that the Federal Reserve (and other central banks) are less likely to engage in the aggressive tightening seen in 2022. However, the Fed and the European Central Bank have already signaled a disinclination to ease monetary policy in the face of the current oil shock. This view is driven by concerns that inflation expectations might move higher if central banks show too great an eagerness to accommodate these kinds of shocks to the economy. If his press conference on March 18, Federal Reserve Chair Jerome Powell emphasized that it was too early to assess the effects of the oil shock on the economy. Over the next few months, much more information will be available. The key variable is likely to be how long this oil shock lasts. Anything beyond three months is likely to do significant damage to the economy—not enough to cause a recession, but probably enough to lead to some easing of monetary policy. A longer price shock (six months or more) or one that pushes prices close to $200 per barrel could well tip the economy into a recession.
