The sharp and sustained rise in the price of oil during the war with Iran is a major warning for the United States economy.
Oil price shocks are one of the most reliable signs of recession. Combined with other threats to commerce in the U.S., the run-up in oil prices should be an alarm bell for officials in the White House and at the Federal Reserve.
Of the 11 post-World War II recessions before the pandemic, 10 were preceded by a rise in oil prices in the preceding months, according to research by James Hamilton, an economist at the University of California, San Diego. The only exception was the downturn that began in 1960.
Since Iran shut down traffic through the key global oil chokepoint of the Strait of Hormuz, the price of oil has soared from under $60 to as high as $112 a barrel for Brent crude, the international benchmark.
“The dramatic slowdown in oil shipments through the Strait of Hormuz definitely increases the risk of an economic recession,” Hamilton wrote in an email to the Washington Examiner. “The key question is how long the conflict continues.”
Hamilton’s research suggests that oil price spikes threaten the economy, regardless of the underlying cause of the higher prices. For example, the price of oil rose sharply because of a classic supply chain disruption during the 1956 Suez Crisis, which threatened Europe’s access to oil from the Middle East. The U.S. went into recession in 1957.
On the other hand, demand-driven price hikes have also preceded recessions, as happened when the price of oil rose nearly 40% at the end of 1999 and beginning of 2000, just as the dotcom bubble peaked and then burst, leading to a downturn.
In other words, a spike in oil prices is a problem for any economy. This time, it hit a U.S. economy that was in decent shape, as unemployment is low, but that had a few storm clouds on the horizon. One was a significant slowdown in job growth. Another one was weak growth in the first quarter.
The longer that the Strait of Hormuz remains closed to oil tankers, the greater the chance that the economy unravels and unemployment rises, said Sean Snaith, the director of the University of Central Florida’s Institute for Economic Forecasting.
“How long is it going to go on, and how severe is it going to get?” he asked. “And I think if you move in either direction in terms of length for severity, you see a heightened risk of recession that comes along with that.”
For its part, the White House maintains that oil prices will quickly drop once the Iran conflict ends, meaning that the threat to the economy is limited. President Donald Trump told the Washington Examiner that the other knock-on effects of the war, such as higher interest rates, will reverse once the war ends.
As the conflict has worn on, he noted, airlines have added baggage surcharges to offset the cost of higher-priced jet fuel. Some shipping companies have also raised prices because of the higher cost of diesel. In time, he warned, consumer products made from petroleum, such as IV tubes, will rise in price.
In time, consumer confidence will fall. Hamilton’s research suggests that falling economic sentiment is one of the main ways that higher oil prices hurt the macroeconomy. That is in large part because drivers suffer higher gas prices every time they fill up, which is likely weekly or even daily.
Consumer confidence reaches record lows
Consumer confidence was already extremely low before the war began. And consumer sentiment fell to a record low in April, worse than it was during the worst days of the Great Recession or the pandemic shutdowns, according to the University of Michigan consumer surveys.
Hamilton said that the other indicators to watch were auto sales and initial claims for unemployment benefits.
Auto sales would suffer if families decided they could not afford a major purchase, especially a gas-powered car. But auto sales rose in March, the Bureau of Economic Analysis reported Thursday.
Initial claims are a high-frequency gauge of labor market health. They are released weekly. They were low throughout March.
Perhaps the biggest threat from rising oil prices, though, would be that they would cause the Fed to think inflation was rising because of loose money, leading officials to implement an unwarranted tightening of monetary policy.
That is essentially what happened in 2008. Although the economy was already weakening by late 2007, the Fed failed to ease monetary policy in tandem because soaring oil prices were propping up headline inflation and masking the underlying weakness in demand for goods and services. From April of 2008 until after the collapse of the investment bank Lehman Brothers in September, the Fed held its rate target at 2%. Some economists have blamed this “passive tightening” for the ensuing massive job losses.
What confused officials is that inflation was high, as high as 5% in the summer of 2008. That often would be a sign that the economy is running too hot, and that the Fed needs to raise rates to constrain spending. In this case, though, it was really just oil prices driving the high inflation. Core inflation, which strips out the prices of energy and food, ran close to the Fed’s 2% target throughout the spring and summer of that year.
One of the officials who was fooled was Kevin Warsh, who was then a member of the Fed’s Board of Governors and is now Trump’s nominee to be the Fed chairman. As late as Sept. 16, after the fall of Lehman, Warsh was more concerned about high inflation than about the ongoing plunge of the economy into recession.
“I’m still not ready to relinquish my concerns on the inflation front,” he said at a meeting of the Fed’s monetary policy committee.
This time around, though, Fed officials seem attuned to the risk that rising oil prices could disguise underlying weakness.
In a press conference last month, Chairman Jerome Powell said that “the long-standing
thinking, put it that way, is that you do ‘look through’ energy shocks,” meaning that the Fed would not raise interest rates in response to higher oil prices. Powell cautioned, though, that the central bank would watch carefully for second-order effects on the economy.
TRUMP SAYS OIL WILL FLOW ‘WITH OR WITHOUT’ IRAN’S HELP, WARNS AGAINST TANKER FEES
Similarly, Federal Reserve Bank of New York president John Williams said this week that he did not expect the oil shock to drive up underlying inflation over the long term.
“Monetary policy today is really well positioned” to respond to the disruptions, Williams said in an appearance on Bloomberg.
“Monetary policy is exactly where it needs to be, and then we can respond if the situation changes,” he added.