”Higher Oil Prices Should Not Stop Economic Growth,” Says Dr. David Kelly, Putnam Investments Economic Advisor

As Hurricane Katrina ploughed through the oil fields of the Gulf Coast, crude oil futures prices briefly vaulted above $70 a barrel. While most attention will be and should be paid to the human toll of this disaster, the surge in oil prices will also have an impact. Moreover, this hurricane-induced spike is just the latest in a long string of increases that once again have made oil the major topic of economic concern across the United States. But when looking at oil and the economy, it is important to recognize a few key realities.

HIGHER OIL PRICES SHOULD NOT STOP ECONOMIC GROWTH

First, higher oil prices, on their own, can slow, but should not stop, the economic expansion. To see this, start by recognizing why rising oil prices are so negative. Why, for example, do higher gasoline prices hurt the economy more than higher milk prices?

The simple reason is that, unlike milk, most of the oil we consume comes from abroad. If the price of a gallon of milk rises by a dollar, the American consumer’s loss is the American farmer’s gain. But if the price of a gallon of gasoline rises by a dollar, the American consumer’s loss is mostly lost to the entire economy.

Recognizing this fact allows us to quantify an “oil tax” as the total dollar cost of petroleum imports relative to total U.S. gross domestic product (GDP). In 2002, the tax was equal to roughly $104 billion, or 1.0% of GDP. By 2004, it had climbed to 1.5% of GDP. And in 2005, assuming prices hold in the mid-$60s for the rest of the year, it should climb to 2.0% of GDP.

Given that oil imports reduced GDP by 1.5% last year and by 2.0% this year, at a first rough pass, the oil tax has directly reduced this year’s economic growth by 0.5%. This year, I expect real GDP to grow by 3.6%. Had it not been for higher oil prices, I would have expected growth to be 4.1%. And if oil prices stay in the mid-$60s, the oil tax would rise to about 2.2% of GDP in 2006, shaving 0.2% off next year’s economic growth rate.

Note that higher oil prices are only impacting the speed of economic growth rather than causing the economy to stall out. Moreover, it is the rate of change in oil prices rather than the level that is key. If prices were to stay at today’s seemingly high levels, they will have a significant impact on economic growth in 2005, a small impact on economic growth in 2006, and no impact in 2007 and beyond.

TODAY’S ECONOMY IS LESS VULNERABLE TO OIL PRICE SHOCKS

Second, the economy is somewhat less vulnerable to oil shocks than it was in the 1970s. Back then, the rising price of oil was essentially a double-edged sword – adding to inflation while simultaneously sucking demand out of the economy.

One edge of this sword is pretty blunt today. In the 1970s, higher oil prices led to higher wage demands while companies passed their own higher energy costs through to consumers. However, because of declining union power, workers have far less ability to extract wage concessions than they did 30 years ago, and wage growth over the past few years has been relatively muted. Moreover, because of a more competitive landscape, companies are having a hard time passing through higher energy costs to consumers.

 Soaring oil and gas prices have not fed through to non-energy inflation                                                    3-                               July      July       year     Annualized                               2002      2005    %Change       % Change      Fuel oil                112.4     221.9      97.4%          25.4%      Natural gas             133.9     200.8      50.0%          14.5%      Gasoline                118.2     192.1      62.5%          17.6%      Jet fuel                 73.2     178.8     144.3%          34.7%       Airline fares           235.1     249.7       6.2%           2.0%      Electricity             135.8     150.6      10.9%           3.5%      Average hourly       earnings              $14.96    $16.13       7.8%           2.5%      Memo: CPI  excluding       energy                 187.7     198.8       5.9%           1.9%  Source: Bureau of Labor Statistics. 

Despite rising oil and natural gas prices, electricity prices were only 11% higher in July than they were three years earlier. Even more dramatic, July was the strongest month in U.S. history for air travel, and jet fuel prices were up 144% from July 2002. Despite all of this, airline fares are up just 6% over the same three years. More broadly, as the American economy has evolved into a service-based economy, transportation costs are a much smaller share of economy-wide costs today and, for the most part, higher oil prices have not led to a ripple effect of higher prices throughout the economy.

HIGHER OIL PRICES HURT SOME MORE THAN OTHERS

The third important point to recognize about higher oil prices is that they don’t hit all of society evenly. Data from consumer expenditure surveys show where the pain is being inflicted.

Who gets hurt by higher energy prices?

In 2003, consumer spending on gasoline, fuel oil, and natural gas combined accounted for just 2.4% of the after-tax income of the richest fifth of households but 11.2% of the after-tax income of the poorest fifth. It accounted for 3.6% of the after-tax income of suburban households but 5.2% of the income of rural households. It impacted the income of the youngest and oldest households more than those of middle age. And despite higher usage of fuel oil in the Northeast, households in the Midwest were most vulnerable to higher energy prices overall.

Sadly, it is the poorest Americans in the regions and areas that have seen the weakest recovery from the recession of 2001 who are being hurt most by higher oil prices. No wonder Wal-Mart is hurting.

However, for the economy overall, the pain is less. In a speech in Wyoming over the weekend, Federal Reserve Board Chairman Alan Greenspan noted some of the shocks the economy has withstood during his long tenure at the Fed, including the 1987 stock market crash and the unprecedented shock of 9/11. Even the credit crunch of the early 1990s and the bursting of the stock market bubble in 2000 were absorbed with the shallowest recessions in the post-World War II period.

Dr. Greenspan suggested that part of the reason was an evolving flexibility in the U.S. economy. I believe it has more to do with the movement of the economy to a more service-based economy and the better use of information. But whatever the reason, it should give pause to those predicting economic disaster from record-high oil prices. Higher oil prices are hurting the whole economy to be sure and some groups far more than others. But so far, it is not enough to put an end to the current economic expansion.

About Putnam Investments:

Founded in 1937, Putnam Investments is one of the nation’s oldest and largest money management firms. As of June 30, 2005, Putnam managed $195 billion in assets, of which $132 billion is for mutual fund investors and $63 billion is for institutional clients. Putnam has headquarters in Boston and offices in London and Tokyo.

The opinions expressed here are those of Dr. David Kelly, Senior Economic Advisor, Putnam Investments. They should not be construed as investment advice and are subject to change with market conditions. All economic and performance information is historical and does not guarantee future results. Please consult your financial advisor for more information. Data come from the Bureau of Labor Statistics and the Bureau of Economic Analysis as of August 29, 2005.

Investors should carefully consider the investment objectives, risks, charges, and expenses of a fund before investing. For a prospectus containing this and other information for any Putnam fund or product, call your advisor or call Putnam at 1-800-225-1581. Please read the prospectus carefully before investing.

Copyright 2005 Putnam Retail Management 228016 8/05