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Oil prices could put consumers over a barrel

This week's surge in oil prices to record highs could hurt the economy more than other increases in recent years because consumers no longer have the cushion of low interest rates to help ease the pain.
/ Source: Reuters

This week's surge in oil prices to record highs could hurt the economy more than other increases in recent years because consumers no longer have the cushion of low interest rates to help ease the pain.

Economic growth has proved hardy in the face of rising energy prices. But that could change, assuming the latest price spike sticks, because the countervailing boost from cheap money and its sidekick, a surging housing market, has faded, analysts said.

Fresh evidence of a cooling in real estate emerged on Tuesday as the government reported a 7.8 percent drop in March housing starts. It is one more piece of data that may persuade the Federal Reserve to call a halt to its two-year campaign of tightening credit.

Also weighing on the Fed will be Tuesday's all-time high in crude oil at more than $71 a barrel on worries that Iran's nuclear stand-off with the West could cut oil exports from the world's fourth-largest exporter.

High oil prices can dampen economic growth by weighing on consumer spending and business investment.

"The danger is that this latest bout of higher oil prices will last longer and have a more detrimental effect on consumer activity," said Nomura Securities Chief Economist David Resler.

"Mortgage rates and long-term rates are certainly much higher than the last time we were flirting with $70 a barrel for oil, and that means we're not going to get the counterweight from low interest rates to ease some of the burden of energy costs," Resler said.

Indeed, long-term interest rates, which govern borrowing costs across the economy, jumped above 5.0 percent last week, the highest in almost four years. They are almost 1 percentage point higher than in September, when oil and gasoline spiked in the aftermath of hurricanes that struck the U.S. Gulf coast, with its heavy concentration of oil platforms and refineries.

The Fed has pushed through five more rate increases since then, as part of a nearly two-year campaign that has pushed official rates to 4.75 percent from 1.0 percent.

Inflation under control
While financial markets still expect another Fed rate increase in May, futures contracts on Tuesday signaled sharply reduced chances of another Fed rate hike in June, to 34 percent from 54 percent on Monday.

The central bank is closely watching inflation measures to make sure that higher energy costs do not spread to other parts of the economy, causing inflation to accelerate. Airlines and taxi companies have passed on higher costs to consumers, but overall inflation has not risen sharply.

Fed Chairman Ben Bernanke, in a letter to a lawmaker released Monday, said the impact on core inflation "appears to have been relatively modest." But he said energy costs have cut the purchasing power of households. In speeches he has cited oil as one of the key risks to the economic outlook.

For now, a strong labor market is helping to underpin income growth and spending.

The four-year bull run in oil prices has trimmed an estimated 0.5 percentage point off economic growth each year, according to forecasts widely cited by economists and the Fed. Oil prices have almost doubled in two years.

Economists at Morgan Stanley estimate the latest upward spiral could knock about $60 billion, or 0.6 percent, off economic growth this summer alone.

"The combination of rising long-term interest rates and higher oil prices puts an unmistakable squeeze on discretionary income," said Morgan Stanley Chief Economist Stephen Roach, who calls the American consumer the weak link in the "global daisy chain.

"The combined impacts of these two developments raise the odds that a tipping point for an unbalanced global economy could be close at hand," he said.

President Bush said Tuesday he is "concerned" about high gasoline prices and that the government will keep a close watch out for profiteering. One of his top economic advisers, Allan Hubbard, said he was worried about the impact on lower-income Americans and owners of small businesses.

"This is not part of their budget," Hubbard told Reuters.

Gasoline is again pushing toward $3 a gallon, a level not seen since the hurricane season last summer. Despite some modest attempts to switch to fuel-efficient vehicles, few American drivers have changed their habits.

Analysts say crude could top $80 a barrel this year, nearing the inflation-adjusted peaks hit in 1980.

"There was no real pressure on consumers up until now," said Lehman Brothers Chief Economist Ethan Harris.

He said there was enough new housing wealth created last year — estimates put it as high as $2.5 trillion — that consumption will prove resilient for some months to come. But if oil remains at elevated levels, it will hurt economic prospects for the second half of the year.

"The risks are that inflation picks up and growth slows down — stagflation," Harris said.