Drowning in Gasoline?

Driving through rural Virginia this past weekend, I noticed something I haven’t seen in a very long time – gas for less than $3.00 per gallon. According to an article in today’s Wall Street Journal (“Consumers Get Relief at Pump”), gas prices in the US are at their lowest levels in 33 months. The article attributes the drop in prices to the boom in domestic oil drilling, which many economists have cited as a major contributing factor in their bullish outlook for the US economy. Together with the drop in interest rates from the September highs, lower gas prices have undoubtedly supported consumer confidence and spending in the face of a government shutdown, fiscal and monetary policy uncertainty, and geopolitical unrest. The key question, though, is whether the drop in gas prices is sustainable (ie, the result of increasing domestic supply) or just the reflection of a temporary drop in demand.

According to financial author Barry Ritholtz, low gas prices are largely the result of weaker demand. Specifically, Ritholtz attributes lower gas prices to three factors: 1) total miles driven in the US is still well below the peak in November, 2007; 2) continued high levels of unemployment (we would actually say low levels of labor participation) means fewer people driving to work; and 3) the “pre-collapse shift to the exurbs — and their much longer commutes — suggests the trend toward ever-longer commutes may have topped out.” If Ritholtz is right and lower gas prices are simply the result of a weak economic backdrop, then it would be logical to expect prices to head back up once economic growth accelerates, right?


Gas data from American Automobile Association.

The price volatility of gasoline is just one reason we remain cautious with regard to future economic growth. In our view, there will be a ceiling on the pace of economic recovery due, in part, to the likelihood that both energy prices and interest rates will spike on any sign of accelerating economic expansion. Yes, gas prices are low now, but the key question is whether lower prices will be sustainable as demand increases. Yes, interest rates (read: mortgage rates) have come down from there recent highs, but will this last as the Fed begins its “taper”?

This is the major negative side effect of the Fed’s loose monetary policy. The Fed has painted itself into a box whereby any decrease in monetary support will endanger the fragile economic recovery. Is it possible that economic growth can accelerate, which by definition means an improvement in aggregate demand, without causing interest rates and gas prices higher? It doesn’t seem likely.

Producing our own energy and reducing our dependence on foreign oil are undoubtedly positive developments. However, demand for gasoline remains cyclically (as well as seasonally) depressed. Therefore, it is premature to suggest that increased US energy production can or will lead to sustained lower prices. For now, the best bet is to assume that gasoline prices, along with interest rates, will wax and wane with the economy. In others words, don’t get used to paying $3.00 or lower for gasoline if and when the economic “recovery” accelerates.