YOU DECIDE: Why are gas prices up?

Date posted: January 21, 2011

Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

I got into a little trouble recently when I told a reporter that the rise in gas prices can be viewed as a positive indicator for the economy. I received several e-mails and calls from people saying I was out of touch and even in the pocket of the oil companies!

Of course, I understand higher gas prices hit everyone’s budget. After all, my decade-old SUV gulps gas. But the relatively low gas prices we enjoyed in 2008 and 2009 — for a while dipping below $2 a gallon — weren’t due to any great improvement in energy markets. Instead, they were the result of something bad: the worldwide recession.

When the economy is weak, it makes sense that less gasoline is used. During recessions, businesses produce and sell less, so there’s less shipping of products across the country. Also, with higher unemployment and tighter family finances, there’s less travel for work, shopping and vacations. Indeed, at the peak of the recession, total mileage driven in the country fell 5 percent. We also consumed 750,000 fewer barrels of oil daily.

And it wasn’t only our country that became a more frugal user of gas. The same thing happened across the world. With less being bought (lower demand in economics lingo), oil and gas prices plunged. This is simple economics at work.

The bottom of the recession occurred in mid 2009. Since then, factories have been producing more, and over one million jobs have been created nationwide. Driving has crept higher and so too has gas usage. All this additional economic activity has reversed the downward trend in gas prices and brought them back to pre-recessionary levels.

The conclusion: the low gas prices we enjoyed in 2009 were an aberration due to the poor economy. We’re now back to “normal” prices of $3 or more for gas as the economy has begun to crawl back.

Yet this creates another worry. Could a continuing rise in gas prices trigger another recession? Aren’t recessions always preceded by a jump in gas prices?

Let me answer the second question first. There certainly have been energy-induced recessions. The two recessions of the 1970s are good examples. But recessions can also begin in other parts of the economy, like the recession of the early 1990s (commercial real estate), the recession of 2001 (tech sector) and the most recent recession (residential real estate). In these cases the higher gas prices that preceded the recession were a sign of a strongly growing economy.

But what about today? Will $3 or $4 gas put the economy back on the mat? When gas prices rise, consumers have less to spend on other products and services, which can lead to layoffs. Lofty gas prices also increase the costs to businesses of producing and selling, creating even more pink slips.

While more expensive gas does slow our economic engine, the economic car can still move forward if our speed is great enough. Studies of the economy have found a 33 percent rise in gas prices will typically cut the economy’s growth rate by 0.3 percentage points. Most economists estimate today’s economy is expanding in the 2.5 to 3 percent range. So a 33 percent rise in gas prices — for example, from $3 to $4 a gallon — would cut economic growth to between 2.2 and 2.7 percent. This is still growth (a recession occurs when the growth rate is negative), but it is slower growth.

One advantage we’ve had in coping with higher gas prices is that other prices in the economy have been rising modestly or not at all. While gas prices have surged from $1.80 a gallon in early 2009 to over $3 today, the overall inflation rate at the retail level has increased less than 2 percent annually. One reason is that expenditures on gasoline account for just 6 percent of total consumer expenditures. So while we’re focused on gas prices because fuel is bought more frequently than just about any other product, gas prices aren’t the driving force behind inflation.

So what about the future? Do economists see higher gas prices? The answer is yes, as long as the economy improves and driving increases. While $4 a gallon gas may not happen in 2011, it will eventually. Few of us will be happy, but we will adapt. Also, look for even more interest in the alternative fuels industry. As gas prices resume their upward march, other fuels become more economically viable.

I’ve learned one lesson from today’s jump in gas prices. Never use “higher gas prices” and “good” in the same sentence! You decide if this is a good rule to follow.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.ncsu.edu/waldenradio/

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