Chilling Headwinds: Energy Costs Stalling the Economy?

Most consumers spend 100% of what they make.  The last dollars are spent on discretionary items, while the first dollars are allocated to long term commitments such as the home, school and car payments.  Somewhere in consumer spending is food and clothing.

If income remains fixed, and costs rise – the first effect is substitution – steak to hamburger, big car to little car.

Still, the consumer continues to spend all he or she make.   And the turmoil in business relate only to less sales at Macy’s and more at Walmart.  Overall the change in the economy is a loss for some, and a gain for others.

If costs continue to rise and income remains flat, some discretionary purchases are eliminated.  Overall spending remains the same, but the number of widgets purchased declines – less units need to be made, and less people are needed to make them.  And energy is a core element of these forces, as the seminal work by James Hamilton has shown with his study of how energy cost spikes have been associated with past recessions.

What is the trigger point for the consumer to shift from substitution to elimination?

Elimination of purchases by consumers recesses the economy.  There is no specific trigger point.  The USA economy has weathered very large inflationary periods without recessing.  Ellen Beeson Zentner, Vice President & Senior U.S. Macro Economist at Bank of Tokyo – Mitsubishi UFJ notes:

Taking a look at historical data back to the 1970’s and relating the energy component of the consumer price index to growth in real consumer spending we can see that a 10 percent annualized growth rate in the 3-month moving average of the CPI for energy appears to be a trigger for a pullback in spending.

The February 2011 the annualized growth in the 3-month moving average for CPI energy was +13.2 percent.  Looking at just energy price increases may only be part of the trigger.  In 2011 the USA has monetary policy stuck in overdrive due to an economy with weak fundamentals, a consumer continuing to unwind its debt load, spending contractions from government entities, and a more globalized economy.

A Federal Reserve study released this week (news here) looking at historical data suggests that Central Banks do not need to react to rising energy prices – as energy prices alone slow the economy causing the demand and prices for energy to fall.  Econintersect suggests this study may not be applicable in a world where China is now the number one consumer of energy.

China likely can grow with rising energy prices as monetary policy has relatively more room to maneuver.

Global energy demand is now less affected by energy use in the USA.  There exists a situation where energy cost can depress the U.S. economy and world energy demand and prices will not fall.  World demand and prices might even continue to rise, thus worsening the U.S. downturn..

The above argument of energy price dynamics is valid if the laws of supply and demand are driving energy prices higher.  Russ Winter posted in the Wall Street Examiner an alternate explanation for higher commodity prices.

Russ points out there is a 90% correlation to the CRB index which 33% of the components are oil based.  Fed Chairman Bernanke has given credit for equities markets gains to QE2.  It is not a stretch to believe it extends to commodities also.

Could the ending of QE2 bring commodity price inflation under control?

I point out that Econintersect and others where pointing to a possibility of a double dip recession during the flat period on the above graph – the USA economy was slowing threatening global expansion.  Commodity prices tend to rise during times of economic expansion, and fall during contraction.

If the global economy continues to expand after QE2 is removed, it is difficult to envision commodity prices trending downward.

Economic News this Week:

Econintersect issued its economic forecast for April 2011 indicating a peaking of this current economic sub-cycle.  In simple words, the same moderate recovery seen in March will continue in April.

This week the Weekly Leading Index (WLI) from ECRI improved from 6.7%  to 6.8%.  This level implies the business conditions six months from now will be approximately the same or slightly improved compared to today.

Initial unemployment claims increased in this week’s release.  The data for the last two months as been quite noisy, and it remains important to follow the four week moving average for analysis of unemployment to smooth out the reporting idiosyncrasies.  Keep in mind the overall trend is lower claims.

The data released this week was positive and consistent with Econintersect’s January, February and March forecasts of slightly improving economic conditions overall.  The economy, similar to this period last year at this time, is gaining strength.

Weekly Economic Release Scorecard:

Item Headline Analysis
April Empire State Manufacturers Survey
Survey looks solid but has an anomaly in backlog
March Industrial Production
Solid performance but note that IP remains at 93.6% of pre-recession levels
March Consumer Prices
Up 2.7% YoY
Consumers may be seeing much higher price increases
March Sea Container Counts
Exports remain at historical highs
Consumer Metrics
Consumer Contraction is now far exceeding the Great recession
March Producer Price Index
Up 5.8% YoY
Rate of rise returned to 6 month average after last month’s surge.
February Business Sales
Size of increase so small it takes a microscope to see
March Retail Sales
Growth trend over last 4 months remains in tight 7% YoY trend
March Retail Sales

USA remains in a retail sales recession
March Import / Export Prices
Prices are up 9% YoY – yet PPI only up 6%???
March Small Business Sentiment
Surprisingly large one month setback in a background of recent up-trending sentiment
March Diesel Consumption
Strong growth
February USA Trade Deficit
Larger than normal decline in imported oil
Retail Sales & Credit

When inflation is factored in, no retail sales growth.  Credit growth is only student loans.

Why voters rejected compensating Europe for losses
Australia Housing Prices

An expert’s view of what is really going on in Oz

A look at the effectiveness of Napa, Sonoma, and Columbia in marketing wines
Las Vegas Properties

Kieth Jurow explores whether it is time to buy rsidential property in Las Vegas
Corporate Forward Earnings

Jeff Miller examines the use of forward earning estimates
Dow Industrials, S&P Index

William Kurtz argues the market has peaked
USA Austerity or Simulus

Elliott Morss looks at if and when the USA should be on IMF standby
Economic Ideologies

Delusional Economics says you need to beware economists with ideologies

Dirk Ehnts argues low interest rates are a transfer of wealth

Michael Hudson shows why Iceland needed to reject paying Europe back
Europe Interest Rate Rise

Dirk Ehnts reviews the conflicts of rising ECB interest rates

Michael Pettis looks at bank reform

Bankruptcies this Week:  Composite Technology (CTC), ReGen Biologics, Fiesta Station (affiliate of Station Casinos)

Failed Banks this Week:

Related Articles

Shocks and Economic Recessions by James Hamilton
Study Says Fed Does Not Need to React to Inflation Caused by Commodity Prices (GEI News)

April 2011 Economic Forecast:  Likely At Sub-Cycle Peak by Steven Hansen

Beware:  Core Inflation Follows Food Inflation by Steven Hansen

CPI Surge Caused by Rising Energy Prices by Steven Hansen

Energy is Surging into PPI Future by Steven Hansen

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