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Hundred dollar oil, five percent inflation, and the coming recession

...[The power of the U.S. Federal Reserve] to contain prices, however, is still not absolute. Constraints remain. Today, one of those limitations can be found in the energy sector where an industry already operating at essentially full capacity has just suffered major, nontransitory capacity losses. Additional capacity reductions can be expected in the next year. Repair of existing capacity, not to mention expansion, will take several years.1

In 2006, inflation rates may rise to above 5 percent in the United States if economic growth continues at current rates, even if the dollar holds its value. Such an increase in inflation would be caused by economic growth that would pull oil prices to $100 per barrel. It is unlikely that the Bernanke-chaired Federal Reserve Board can or will tolerate such increases in inflation. Interest rates will rise. Output growth will slow and the United States could fall into recession. This recession, like the previous three instances, will be caused by constraints in the energy sector.

...

From the spring of 2004 on, the world has confronted a genuine constraint, one not related to crude oil but to refining capacity. In the United States, natural gas supplies have been squeezed as well. Product prices have surged and crude has followed. The refining constraint has occurred because world refiners have been unable to meet consumer demand for products meeting specifications established by environmental regulators in the major oil-consuming economies. Rapid, partially unexpected increases in demand for products in China, India, Europe, and the United States have required substantial product price rises. Arbitrage has caused crude to follow.

The rise in energy prices creates a new problem for economic policymakers because the capacity constraints cannot be easily addressed over the next four years. Increased demands for products must be met by sharply higher prices to balance consumption with capacity. Central bankers must fight a new war that is more challenging than constraining inflation expectations has been of late, given weaker pricing power and labor bargaining strength.

...

Today central banks face a new constraint on their action from a vertical (totally inelastic) supply curve for energy. For reasons discussed below, the constraint from the energy sector will be one of the most important factors—if not the most important—facing monetary policy officials for the next three to four years if the global economy continues to expand. The energy constraint must dominate policymaking because it will almost certainly limit the growth of potential GDP for the next five years. Indeed, the energy constraint could propel the U.S. economy into a deflationary cycle if it is improperly addressed. Unfortunately, the energy constraint, to this date, has been misunderstood at the Federal Reserve, if speeches by Greenspan in the last year of his chairmanship are representative.

...

Energy Supply Constraints

The economies of most major industrialized nations—including China, the European Union, the United States, and, indirectly, Canada—face energy constraints. Some of these constraints result from environmental regulatory programs, others from the failure of capacity expansion to keep up with economic growth, while still others occur as the result of natural disasters. Environmental regulations adopted across the globe have crimped fuel supply. Available supplies are also limited as a result of the energy industry’s underinvestment in downstream capacity. Finally, a series of major hurricanes have disrupted U.S. natural gas supplies.

...

The product price rise will pull up crude prices. There is a little-understood relationship between product and crude prices. Across the globe, traders for major oil companies, oil trading firms, and investment banks conduct continuous arbitrage in oil markets. These traders understand that different crude oils produce different “slates” of products such as gasoline, heating oil, and jet fuel. As product prices change, traders will alter their bids for crude. As crude prices change, they will alter their offers for products. In the end, the crude price will closely track the value of products produced by the crude.

This product/crude relationship implies that the product shortage noted above will raise crude prices in the United States and across the globe. Tight gasoline markets next summer could easily lead to crude prices of around $100 per barrel. Our analysis indicates that a crude price increase to $100 would boost U.S. inflation rates above 6 percent.

In summary, economic policymakers can expect continued increases in retail energy prices of a magnitude similar to that of price increases observed over the last year. There is no reason to foresee a reduction in energy prices in 2006 or 2007 if the global economy expands at the expected rate.

...

To make the relaxation of environmental rules palatable to environmentalists, policymakers may also want to consider adopting much higher energy taxes. Indeed, cuts in consumption represent the only other way to deal with the supply constraint. Evidence shows that large taxes will achieve this. These taxes need not have serious long-term impacts if other taxes are reduced to maintain fiscal neutrality.

One way to recycle the revenue while aggressively promoting conservation would be to link the higher gasoline tax to a repurchase program for large cars, SUVs, and trucks. Taxes on energy use and/or relaxation of environmental regulation with or without programs to repurchase inefficient autos are essential today to restore the supplyand- demand balance at lower price levels and create a supply cushion. The only alternative is recession since the central bank cannot do anything about a vertical energy supply curve.

Editorial Notes: Go to the original for the full article (PDF). Prominent energy economist Verleger predicts inflation and/or recession on purely economic grounds - peak oil isn't necessary to make his case. I wonder what his thoughts are on peak oil, and how that would affect his long-term analysis. From Verleger's Establishment credentials, it's reasonable to guess that the views in this article will be widespread in US policymaking circles. Wouldn't it be wonderful if all economists could write articles as readable as this one? Related: Energy: The Gathering Storm, essay by Verleger (PDF), September 2004 As Oil Prices Broil... (subject of 2004 Washington Post column by David Ignatius) - his views are prescient Interview on NPR (2004) According to The Globalist:
Dr. Philip K. Verleger, Jr. is president of PKVerleger LLC and a Senior Advisor to The Brattle Group, a Cambridge, Massachusetts economics consulting firm, Dr. Verleger specializes in the study of energy commodity markets. The author of over 100 articles and books on energy economics, Dr. Verleger has testified frequently as an expert witness... Dr. Verleger has held positions at the President's Council of Economic Advisers, the U.S. Treasury, the Institute for International Economics, Yale University, the University of California, and various firms in the private sector. He is a member of the National Petroleum Council and the Council of Foreign Relations. Dr. Verleger received his Ph.D. in economics from the Massachusetts Institute of Technology in 1971.
-BA

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