Calculated Risk sums up recent oil and gas prices nicely a few days ago (bold emphasis mine):

Oil and gasoline prices are probably the biggest downside risk to the economy right now. Oil prices are off slightly today, from the WSJ: Oil Prices Ease

The front-month July Brent contract on London’s ICE futures exchange was recently down 35 cents, or 0.3%, at $114.68 a barrel. The front-month July contract on the New York Mercantile Exchange was trading lower 43 or 0.4%, at $100.16 per barrel.

Looking at the following graph, it appears that gasoline prices are off about 18 cents nationally from the peak. This graph suggests – with oil prices around $100 per barrel that gasoline prices will fall into the $3.50 – $3.60 per gallon range in the next few weeks.

However that just takes us back to March pricing – and that was already a drag on consumer spending. I’ll have more on the overall economy later.

The risk is real.  A continued high level of gas and oil prices threatens to slow down the U.S. economy.  Indeed the results of 1st qtr 2011 GDP and the May employment report tend to indicate the economy is slowing again.  How much of an effect?  Well James Hamilton of Econbrowser, one of the better academic econometricians and also one who follows oil prices closely points out that Americans buy approx. 12 billion gallons of gasoline each month. So when gas goes up by $1 per gallon like it has since February, that’s $12 billion less per month to spend on other things.  That translates to $144 billion per year or approx. 1% of GDP.  So, continuing this kind of back-of-the-envelope calculation, if gas prices continue to stay up near $4 per gallon, we can expect GDP growth to be 1 percentage point lower than it would have otherwise been.  As Hamilton points out, that by itself is not enough to put us into a recession, but it can slow things quite a bit.

But, Hamilton also points out that 10 of the last 11 recessions have been preceded by sharp run ups in the price of oil.  The likely impact of the recent increase in oil/gas prices will definitely include some immediate slowing in GDP growth.  I think we’ve already seen that.  But the more significant risks are still to come.   If prices stay up for the next year or more, then the effects will begin to compound.  Oil price increases have a multiplier effect, much like government spending and taxes.  When the price of oil goes up, the initial reaction is to cut spending elsewhere to continue fund our purchases of gas. After all, we gotta go to work and school.  But then, as purchases of other goods decline, layoffs begin in those other industries.  The increased unemployment in those other industries reduces total consumption spending even more and causes new rounds of cutbacks.  Hamilton points out that the last time we saw this rapid run up in gas prices in 2007-8, it wasn’t until many months later that the real devastating impact was felt.  Overall, it doesn’t bode well for fall 2011.

But why are oil and gas prices so high?  And why did they rise by approximately 25-30% at the end of February?  I think I’ll make that the subject of another post.