Will Higher Oil Prices Cause a Recession?

 

Takeaway

  • Higher oil prices could cause a recession if the Fed reacts to them by raising interest rates.

A blog reader forwarded an email to me that he had received from a brokerage firm.  The email contained a chart showing that spikes in oil prices always were followed by a recession.  Here’s the chart:

It’s true, that every recession has been preceded by a spike in oil prices.  Yet, I think that the chart is somewhat misleading.  If you look at the second chart (below), you’ll see that each recession was also preceded by the Fed raising interest rates.  The Fed was trying to curb inflation and slow the economy.

So, the question that you have to ask is whether higher oil prices are going to result in inflation and result in the Fed tightening monetary policy.  If you believe this will happen, then it makes sense to believe that higher oil prices will lead to a recession.  Personally, I don’t believe this is what will happen.

Here’s the “higher oil prices will lead to a recession” argument:

  1. Oil prices could go even higher if the unrest in Egypt and Libya expands to major oil producers like Saudi Arabia and Iran.  (Saudi Arabia showed signs of fear last week when they announced $22 billion of giveaways to their people — clearly trying to prevent any unrest.  At the same time, the markets were spooked by Iranian warships in the Suez Canal.)
  2. High oil prices can work their way through the economy because all goods have to be transported (and energy is also an important cost of manufacturing).
  3. Higher oil prices are like a tax (that doesn’t reduce our deficit) — if consumers spend money on gas, it reduces their spending on other goods.  With imported oil, we are spending money and our GDP is not growing.

Ultimately, I think you have to ask yourself whether you believe the chaos will spread to Saudi Arabia and (if it does) whether the Fed will believe that higher interest rates are the right reaction to higher oil prices.  My guess (and that’s all it is) is that the current run-up in oil prices will not lead to a recession.  But, I’m really watching to see if the Saudis will have the guts to rise up against their government.

Previously posted on Sandy Leeds’ blog, Leeds on Finance.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance, McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

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