Crude Reality: Slow Growth, but Recession Unlikely

Editor's note: This is a bonus story from Anirvan Banerji, whose commentary usually appears only on RealMoney. It originally was published on Aug. 31 and since updated. We're offering it today to TheStreet.com readers. To read Banerji's commentary every day, please click here for information about a free trial to RealMoney.

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The past does not repeat itself, but it rhymes. -- Mark Twain

Four years ago, the Economic Cycle Research Institute's research correctly flagged the recession danger from the oil price spike. That call was based on the so-called Katona effect -- the late George Katona's notion that the timing of consumer spending is linked to price-level volatility, especially when there's an oil price spike. He based his view on what he'd learned from the University of Michigan's consumer surveys: When consumers encountered an unexpected jump in prices, consumption fell and savings increased.

After surging toward $50 per barrel this summer, oil prices peaked on Aug. 19 and then fell sharply to $40 per. But with global energy demand rising rapidly in the foreseeable future, this is hardly the last spike we'll see. Indeed, crude prices are on the rise again this week amid concerns about Hurricane Ivan's impact on production in the Gulf of Mexico.

So, would a fresh spike in oil prices cause a new recession today? In reality, it's quite unlikely, even though a similar-sized oil shock helped trigger the 2001 recession. Why? Because the resistance of an economy to shocks, including oil shocks, changes over the business cycle, and the economy's vulnerability to such shocks is currently limited.

Still, it's worth examining the validity of both the fearful and the complacent responses to the latest oil price spike.

The pessimists noted, quite correctly, that every U.S. recession in the last 30 years was set off by an oil shock. In their view, this year's oil price spike was comparable to earlier shocks that had helped trigger recessions, and would have a similar effect.

More sanguine economists responded that the U.S. economy is no longer susceptible to oil shocks, because inflation-adjusted oil prices are much lower and the economy is much less energy-intensive than in the mid-1970s and early 1980s. But this argument was just as valid before the 1990-91 and 2001 recessions, so how come the oil shocks weren't so innocuous at those junctures?

In fact, oil shocks are still capable of tipping the economy into recession. Only this is not true under all conditions.

Katona Revisited

To show the Katona effect, we need to measure consumers' "surprise." Just as we did four years ago, we measured the volatility of the consumer price index by using its 12-month moving standard deviation, which, when plotted on an inverted scale against consumer spending growth, shows a close fit.

Volatile Consumers Energy shocks lead to falling consumption and higher savings Click for full-size image

Source: Economic Cycle Research Institute (ECRI)

This July, CPI volatility jumped to a 13-year high -- yes, worse than in 2000. Consumer spending growth also dropped sharply before rebounding a bit in July. Thus, the pessimists are right about the magnitude of this oil price shock being comparable to the one before the last recession, when inflation-adjusted oil prices were almost as high and the economy was about as energy-intensive as it is today.

The Katona effect works because increased inflation uncertainty makes consumers build up precautionary reserves in the form of savings balances. But when the rise in CPI volatility is driven by higher food or energy prices, it hurts spending even more, because people have no choice but to buy food and gasoline. Basically, greater spending on non-discretionary items reduces the money available for discretionary spending on deferrable goods like cars and furniture, hurting consumer spending.

Taking the Lead

The economy's vulnerability to shocks (from oil, or other factors) is best measured by good leading indices, which is why they can accurately predict recessions.

Four years ago, I noted 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." Luckily, that's not the case today.

But that does not mean the recent weakness in economic growth is just a "soft patch" that will recede as oil prices drop. Unfortunately, that's also improbable.

In fact, ECRI's leading indices, including the Weekly Leading Index (WLI), telegraphed the current slowdown months ago. That's why we predicted last spring -- before the "soft patch" became apparent to most -- that U.S. economic growth was "set to moderate in the months ahead."

Leading Down, Not Out The WLI slides but isn't rolling over

Source: ECRI

To the extent that recent growth was hurt by the surge in oil prices, it's fair to expect some recovery as oil prices fall. But WLI growth has dropped from a 20-year high last summer to a 16-month low today, and there's no sign of an uptick.

In other words, while a recession remains unlikely, a return to robust growth is nowhere in sight. This is no temporary "soft patch" but a broad slowdown that will last at least until year-end. It's also part of a global industrial slowdown that's emerging in all the major economies.

In the years ahead, soaring energy demand from China and India will likely raise the long-run trajectory of energy prices. Thus, future oil price spikes might be even bigger. If they happen to hit at points in the business cycle when the economy is vulnerable to shocks, they could easily trigger new recessions and fresh job losses. Under the circumstances, it would be wise to keep an eye on the leading indices that can accurately gauge the timing of such economic fragility.

One final note: In the spring, I showed a chart of ECRI's Leading Home Price Index (LHPI), which has correctly predicted the persistent rise in home prices during this business cycle. But the LHPI now seems to be leveling off. Is an actual home price downturn next? It's too soon to tell, but stay tuned.