The Big Idea
Energy price arithmetic
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With oil prices more or less stable in recent days and with a clearer view of how US energy prices have reacted to the disruption in the Middle East, it is an opportune time to walk through some of the basics of how the energy price shock is evolving and what impact it will have on the economy. In particular, at current prices, headline inflation is likely to accelerate by up to a percentage point in response to the conflict.
Identifying the magnitudes
Just before the beginning of the conflict, US consumers spent around $420 billion at an annualized pace for gasoline and another $32 billion for heating oil. That compares to overall consumer spending of $21.6 trillion. Gasoline consequently has a weight of just under 2% in the PCE deflator while heating oil accounts for another 0.1%.
As of this writing, retail gasoline prices have risen since the end of February by between 35% and 40%. Applying that change to the dollar amounts above, the higher prices, over the course of a year, would cost consumers somewhere in the neighborhood of $150 to $180 billion, or $12 to $15 billion a month. This amounts to roughly half a percentage point of GDP.
As an aside, as economists have been discussing for months, federal individual income tax refunds this year are running well above year-ago levels, as households benefit from the tax changes implemented in last year’s fiscal package. Withholding tables did not change until January 1, so many households had lower than projected 2025 tax liabilities and consequently received unusually large tax refunds. Through the week of April 10, federal individual tax refunds were running almost $32 billion above the corresponding year-ago total. By comparison, last year at this time, the year-over-year advance was just under $10 billion.
In what might be considered a fortuitous coincidence, the windfall in the form of tax refunds in the aggregate may be large enough to offset the first couple of months of the energy price shock for households.
Inflation impacts
The weights of gasoline and heating oil in the CPI are somewhat larger than the above-mentioned PCE deflator weights. As of February, gasoline accounted for almost 3% of the CPI while heating oil accounted for 0.1%. In round numbers, gasoline and heating oil account for about 2% of the PCE deflator and 3% of the CPI.
Another key point is that gasoline prices typically rise this time of the year anyway. The seasonal factors assume a cumulative 10% increase in gasoline prices in March, April, and May, so the seasonally adjusted rise due to the Middle East conflict will be less than the raw gain. For example, gasoline prices rose by 24.9% in the March CPI, but the seasonally adjusted increase was “only” 21.2%. In any case, if gasoline prices surge by 40% over the three months, the seasonally adjusted jump will only be about 30%. This may limit the impact of the drag in dollar terms to somewhat less than the figures noted above.
In any case, the March surge in gasoline prices added roughly 0.75 percentage points to headline CPI. While the level of gasoline prices has leveled off and actually come down slightly over the past week, the monthly average for March ($3.70 a gallon for regular) was sharply lower than the month-end level ($4.06). As a result, the April average is likely to post an increase somewhere in the neighborhood of 10% if prices stay near the current level for the rest of the month, which would be about a 5% seasonal adjusted advance. Such a result would add another 17 bp or so to headline inflation.
We are on pace for the surge in gasoline prices to add just under a full percentage point to the CPI over the March-April period, or about six tenths of a percentage point for the PCE deflator.
In contrast to oil prices, which are essentially global (there are regional grades, such as WTI and Brent, but prices around the world move mostly in tandem), natural gas markets are local. While natural gas prices have surged in Europe and Asia (because those regions tend to import significant amounts of LNG from the Persian Gulf), natural gas prices in the US have actually fallen since the end of February, down by around 10%. The impact of gasoline and heating oil represents a full accounting of the direct impact of the energy price shock on consumer prices. Note I am not focusing here on secondary effects, like higher airfares, heightened shipping costs that feed through into good prices generally. This contrasts sharply with most economies in Europe and Asia that are dealing with sharp price increases for both petroleum products and natural gas.
Where next?
Retail gasoline prices surged quickly in March and have plateaued since late last month (Exhibit 1). Based on this trajectory, the near-term projection is solely a function of what happens from here. That is, the monthly average for April and the current level are close, so that a roughly flat performance from here would yield little change in the unadjusted figure for May, which would mean a slight negative contribution in seasonally adjusted terms.
Exhibit 1: Regular unleaded retail gasoline prices
Source: AAA.
Having said that, the situation is clearly fluid. Prices could move drastically higher or dramatically lower, depending on developments in the Middle East.
Broader view
These figures offer a limited window of the aggregate impact of the energy price shock on the US economy. In addition to the consumer spending implications for the economy, businesses will be impacted as well. Most businesses will see their input costs rise, while domestic energy producers will enjoy a massive windfall. Perhaps these effects will offset, but it is difficult to say with precision.
More importantly, heightened uncertainty could lead businesses and households to delay decisions, perhaps postponing investment projects, hiring, or, in the case of consumers, major purchases. As long as the energy supply disruptions prove temporary, this should not be a major problem for the economy, a shuffling of the timing of transactions but not a sizable drag over time. However, if the outcome of the conflict creates persistent constraints on global oil flows or if there is not a sufficiently clear resolution to restore confidence in the outlook, then the fallout could prove larger or more lasting. For now, my baseline expectation is that the downside growth implications and upside inflation risks will be predominantly temporary and short-lived, but that obviously remains to be seen.
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