By John W. Schoen Senior producer
msnbc.com
updated 2/25/2011 10:53:50 AM ET 2011-02-25T15:53:50

Oil is nothing less than the life blood of the U.S. economy.

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While it's impossible to know the full impact of Arab uprisings on the long-term price of oil, one thing is clear. Every extra dollar consumers and businesses have to spend on oil takes another little bite out of economic growth.

“Higher oil prices take purchasing power away from the consumer,” said Mohamed El-Erian, co-chief investment officer at money manager PIMCO. “They transfer income to the rest of the world and they increase import prices. Put all that together and it means lower growth and higher inflation.”

The shockwaves reverberating through the global oil supply chain this week come just as the U.S. economy is finally getting back up to speed after the deepest recession in 70 years.

On Friday, the government lowered its estimate of the nation’s Gross Domestic Product for the last three months of 2010 to 2.8 percent annual growth rate from its initial 3.2 percent estimate.

Story: U.S. economy growing more slowly than initially estimated

State and local governments, wrestling with budget shortfalls, cut spending at a 2.4 percent pace. That was much deeper than the 0.9 percent annualized cut first estimated and was the most since the start of 2010.

Recent data from separate reports show a fragile recovery gradually picking up speed, however. Corporate profits are up. New claims for jobless benefits fell below 400,000 last week, lower than expected. Durable goods orders rose 2.7 percent last month, the biggest increase since September as the manufacturing sector continues to find a solid footing.

Next week’s government’s employment report is expected to show a relatively strong gain of 150,000 new jobs in February, after January’s dismal, storm-battered gain of just 36,000.

Story: Sluggish new-home sales drag on economy's growth

But the upbeat outlook has been rapidly overshadowed by an ongoing Arab uprising that threatens to throw a major monkey wrench into the machinery of the global economy. 

This week, the uprising in Libya, a major oil producer, sent oil prices spiking to $120 a barrel before settling back after Saudi Arabia assured the markets it would make up any lost supplies. The Saudi regime’s promise of a massive $37 billion investment in a variety of domestic programs also helped calm market fears that unrest in the kingdom could threaten the flow of some 10 percent of the world’s oil supply.

For now, U.S. refiners are well-supplied by oil producers other than Libya. Canada, Mexico and Saudia Arabia are their top three import sources. Supplies are so abundant that the U.S. benchmark price, known as West Texas Intermediate, is trading at a substantial discount to the more widely-followed Brent price, which based on oil produced from Britain's North Sea.

But because oil is traded globally, the spot price of the next barrel sold is based on minute-by-minute market prices. As supplies tighten, a barrel of oil is worth what the latest bidder is willing to pay for it. So no matter where the oil comes from, supply shocks ripple immediately though the global market.  

As a result, oil traders and analysts devote much of their energy to anticipating the market's next move. But economic forecasters say their computer models are ill-suited to predict the outcome of turmoil in more than a half dozen Arab states.

"Since the first oil embargo in the 1970s, what we've proven we're terrible at is figuring out what the next political uprising or change is going to be in very opaque political systems," said Oppenheimer Fund chief economist Jerry Webman.

The impact of higher oil prices on economic growth, though, is much less opaque.

For consumers, the higher costs of gasoline and home heating oil act like an immediate tax, diverting dollars from other purchases. Consumer spending makes up more than two-thirds of U.S. GDP, so the impact is felt quickly.

Economists estimate that a sustained oil price at current levels of about $100 a barrel would wipe out about half of the positive impact of the government's $120 billion payroll tax cut. At $120 a barrel, the entire impact of those tax cuts would be neutralized.

Oil price hikes also depress economic growth by raising the cost of raw materials made from petroleum — everything from asphalt to plastics. Higher jet fuel prices put pressure on airlines to raise ticket prices. Higher diesel fuel prices drive up the cost of shipping and construction.

Price pressure from higher raw materials costs was building well before the Arab uprising sent oil prices skyrocketing. Now, companies are having an even harder time holding the line on the price of consumer products.

On Thursday, products giant Procter & Gamble said it was raising prices to cope with a run-up in commodity costs and turmoil in the Middle East. Safeway said that higher gasoline prices could squeeze profit margins in the current quarter.

Story: P&G boosting prices amid rising raw material costs

The second second-biggest U.S. supermarket operator said it's not yet clear how high prices have to go before consumers — still battered by high unemployment, stagnant wages and falling home values shoppers — decide to tighten their belts.

"We are not seeing a demand-depressing effect, and the reason is because consumers in the main, particularly our consumers, are feeling better off than they were a year ago," Safeway Chief Executive Steve Burd told a conference call with Wall Street analysts. "It's when inflation gets to 5 percent that you can have a demand-depressing result."

Burd predicted that "virtually all" of Safeway's suppliers would raise prices by the end of 2011 and said he Safeway would raise its prices to offset those higher costs.

On Thursday, the Agriculture Department warned that U.S. consumers should brace for rising food costs this year as higher commodity and energy prices make their way to store shelves. Food prices are forecast to rise a sharp 3.5 percent this year — nearly double the overall inflation rate — with most of those increases coming in the second half of the year.

Though food and energy prices are expected to crimp spending, overall inflation forecasts remain relatively tame. That's largely because there are few signs of the wage inflation that was a key driver of the last bout of hyperinflation, in the 1970s. High unemployment, weakened labor unions and continued gains in productivity are expected to keep labor costs in check.

There are also fears that inflation pressure could be building thanks to the Federal Reserve's massive $600 billion bond-buying spree that ends in June. That policy, called quantitative easing, is designed to spur growth by keeping borrowing costs low. Critics both within and outside the Fed argue that the program, which amounts to flooding the economy with freshly-created money, has had a limited impact that doesn't justify the risk of all that cash creating conditions for runaway inflation.

Story: Fed's Bullard says it's time to debate completing QE2

That puts the Fed in a difficult position if the U.S. economic recovery begins to stumble under the weight of higher food and energy prices. With interest rates already at zero, and Congress and the White House in no mood to approve more fiscal stimulus, support is waning for the central bank's best remaining policy fix for flagging growth.

"Over time, the benefits (of quantitative easing) are starting to go down and the costs and risks are starting to go up," said El-Erian. "That's true not only from an economic perspective, but from a political perspective. I doubt we're going to see (another round.)"

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