Call it the Oil Recession

The economy's humming along, no more interest-rate hikes are in sight, and the markets are starting to feel comfortable again after the inflation scare last spring. Sure, the euro's tanking, but isn't that their problem? True, oil prices are at decade highs, but in inflation-adjusted terms that's still moderate. Why worry?

I'll tell you why. The fact is, throughout the last 50 years, there has never been a spike in oil-price inflation of this magnitude without a subsequent recession. That's right -- never. And a spike in oil-price inflation preceded almost every recession.

Why is that? To understand the link, it's useful to examine the so-called Katona effect, named after the late George Katona of the University of Michigan. Katona was an economist and psychologist who formulated a view that the timing of consumer spending is linked to price-level volatility. This view was based on what he had learned from his consumer surveys: When consumers encountered an unexpected jump in prices, consumption fell and savings increased.

Measuring the Unexpected

The trick to proving the Katona effect is finding a measure for how consumers may be "surprised." To measure the volatility of CPI , I used a 12-month moving standard deviation of the CPI, which, when plotted against a measure for the pace of consumer spending, shows a surprisingly close fit.

The Katona effect is found quite clearly in the data for the U.S. and several other countries. Since last year, with inflation rising rapidly, price volatility has risen to a nine-year high. In response, growth in consumer spending has already dropped to a two-year low, and if the Katona effect continues to hold, may soon drop further.

The Key Is Uncertainty

It isn't hard to understand why the Katona effect provides such a keen insight into consumer psychology. When price volatility rises, it increases inflation uncertainty -- and that causes the consumer to build up precautionary reserves, in the form of savings balances.

Also, a rapid pickup in the CPI -- especially if it arises from higher food or energy prices, like now -- causes diminished discretionary spending. That's because a bigger part of the consumer's budget is going to nondiscretionary expenses. As a result, discretionary spending, such as that spent on deferrable goods like cars and furniture, suffers. This, in turn, ultimately depresses overall spending.

The Current Problem

How much has food and energy price inflation risen? Energy inflation already spurted to a two-decade high this year, and if oil prices keep spiking, it may go higher still. In case you hadn't noticed, even food-price inflation is now at a 41-month high -- and that's according to the government's numbers (For anecdotal evidence about food-price inflation, see Herb Greenberg's column titled "Taking a Closer Look at the Honey Well" ).

What it adds up to is the possibility of a sharp slowdown in consumer spending, possibly even the sort of spending decline that triggers a recession. Under the circumstances, underlying inflation pressures are not a worry -- in fact, the Future Inflation Gauge dropped for the fourth-straight month in August, signaling a benign inflation outlook.

Rather, the concern is that the leading indicators of growth may be starting to roll over, and further spikes in energy prices could tip the economy over into its first downturn in a decade. If the Fed is able to avert a recession after price spikes of this magnitude, that would be a first. Fact is, we've never been able to avoid a recession after this big a spike in oil-price inflation -- so that's already something to worry about and watch for.

Finally, if such a recession hits, it would be an international one, and therefore especially severe. Apart from the fact that a U.S. downturn would drag many countries down with it, other countries are at least as vulnerable to rising oil prices as we are.

And in case anyone thinks the eurozone is a safe haven, remember that oil is priced in U.S. dollars. So, while oil prices may have tripled in the U.S. since early 1999, the drop in the euro has made them quadruple in the eurozone, making the Katona effect that much worse in Europe.

The bottom line is, don't be misled by any jump in headline inflation numbers. The danger has now shifted from inflation to recession.