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Rising oil prices threaten to slow economy

With crude oil prices approaching $50 a barrel, many economists are beginning to worry about the impact on an economy that already is going through a soft patch.
/ Source: msnbc.com

Last month Federal Reserve Chairman Alan Greenspan told Congress the economy was suffering from a surge in energy prices that he considered “transitory.” But with crude oil prices approaching $50 a barrel, many economists are beginning to worry this latest price spike might last longer than expected. At least one Wall Street forecaster is warning of a “shock” that could tip a vulnerable economy into recession. Most analysts disagree with that view but say the rising price of oil already is slowing global economic growth.

The gloomy prognosticator is Stephen Roach, chief global economist of Morgan Stanley, who warned this week of the “mounting perils of another energy shock.” “Under the presumption that such prices stick near current levels, the outlook is worrisome, to say the least,” he wrote in a research note. “Just as the previous three oil price disturbances led to recession, there is good reason to fear a similar outcome in 2005.”

Roach is known as one of the most pessimistic economists on Wall Street, but he is far from the only one worried about the implications of rising oil prices.

“If these levels are sustained you can start marking down global growth in 2005,” said Joseph Quinlan, chief market strategist for Banc of America Capital Management. “Not dramatically, but still enough to knock some of the steam out of the synchronous global expansion. And with weaker growth come weaker earnings.”

Gene Huang, chief economist of FedEx Corp., said the price of oil has become the hottest topic in meetings he attends with other economists and executives, surpassing terrorism as the No. 1 concern of forecasters. Not only are higher gasoline prices acting as a tax on consumers, but the surprising surge has contributed significantly to weakness on the stock market, affecting the economy through the wealth effect, he said.

“When oil prices exceed market expectations by a significant margin it tends to depress equity markets,” he said.

High oil prices also are becoming an issue in the presidential election campaign, with Democratic challenger John Kerry’s campaign accusing President Bush of “standing still” while oil prices skyrocket. And Kerry’s surrogates have pointedly noted the fact that much of the latest oil price surge has been blamed on continued instability in Iraq.

In addition to concern about Iraq, oil is being driven higher on global markets by uncertainty in Russia’s oil industry and fears of a terrorist attack on Saudi  Arabian facilities. With such an apparently large risk premium built into the price, some analysts believe a bubble is forming, driven by speculative buying. But analysts have been predicting for months that oil would drop back to the $30-a-barrel range, and instead prices have surged to record highs day after day, soaring more than 15 percent in the past month alone.

Adjusted for inflation, oil prices are still a bit below the peak hit in the 1990 run-up to the first Gulf War. But prices are well above any sustained levels seen since then, and far above the inflation-adjusted average of about $27 a barrel than U.S. businesses and consumers have been accustomed to since the late 1980s.

Ethan Harris, chief U.S. economist for Lehman Bros., said the high oil prices are “a big chunk of the story” behind an economic soft spot this summer that has slowed consumer spending and spurred businesses to cut back on hiring.

“We assume the oil price run-up we’ve seen so far is slicing a little more than a point off growth right now,” he said. That’s assuming oil doesn’t continue to surge. … It’s a legitimate risk, and I don’t think anyone has a good handle on where it’s going to settle down.”

Resistant economy
While oil shocks preceded U.S. recessions on three previous occasions beginning with the 1973 Arab oil embargo, most analysts believe economic growth is robust enough to withstand the latest challenge.

“High oil prices alone cannot cause a recession, but they can contribute,” said Thorsten Fischer, senior economist at Economy.com. “If the economy is weak or softening they do make a difference.” Higher oil prices already have trimmed growth, he said, but he said global production will continue to meet demand. And he predicted prices would fall as it becomes clear “ the size of the risk premium is out of proportion to the risk.”

Although oil prices are up 60 percent over year-ago levels, that is a far cry from earlier energy shocks. In 1973 oil prices quadrupled to $16 a barrel from just $4. In the aftermath of the Iranian revolution of 1979, prices nearly tripled, and prices briefly doubled after Iraq invaded Kuwait in 1990.

In addition, the U.S. economy is more resistant to oil price hikes than it was even 15 years ago because of the shift away from energy-intensive manufacturing to more efficient economic activity in high technology and the service sector. The U.S. economy uses 46 percent less energy per unit of gross domestic product than it did 30 years ago, Morgan Stanley calculates.

But meanwhile consumption is rising rapidly in developing countries like China and India, keeping global supplies tight. The global economy demands 81 million barrels of oil a day, and producers are pumping out only 82 million barrels, figures Huang of FedEx. And low prices have offered little incentive for producers to develop new fields in recent years, he said.

“Hopefully this will accelerate the investment in crude oil exploration and refinery activities, and more effort in alternative energy use,” he said.

The rising price of oil might not throw the world back into recession, but it does complicate the task of the Federal Reserve, which began raising interest rates June 30 after cutting them to their lowest levels in 46 years. Initially rising energy prices tend to sap consumer demand, but over the long run they can also harm the economy by creating inflation. And with interest rates still at unusually low levels, most analysts expect the central bank to raise rates at least one more time at the next meeting of policy-makers Sept. 21.

“From there it becomes much more interesting,” said Harris. With growth slowing, Fed Chairman Alan Greenspan and his colleagues may elect to move to the sidelines after a “very gentle rate hike cycle,” he said.