Economic consequences of falling oil prices

VI've maintained that rising oil prices put a significant burden on the U.S. economy in recent months. How much will falling oil prices help to alleviate those concerns?

Certainly rising gasoline prices were one factor in this year's plunging consumer confidence. With prices now falling, the Reuters/University of Michigan index of consumer sentiment is up slightly for the last two months. But it still has a long way to go before you'd describe consumers as upbeat.

Reuters/Michigan index of consumer sentiment. Data source: FRED and Market Watch.

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Falling oil prices also mean immediate relief on inflation. The energy price decreases over the last two months should subtract a full percentage point from the 5.6% year-over-year CPI inflation reported by the BLS last week. But again it will take a lot more to bring headline inflation back to comfortable levels.

Year-over-year percent change in seasonally adjusted consumer price index (red) and consumer price index less energy (blue). Source: FRED.

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Sometimes the stock market has taken lower inflation to be good news insofar as it gives the Fed breathing room to lower interest rates. But I have been skeptical of the Fed's ability to stimulate the economy with further rate cuts, and agree with Tim Duy that the main effect of falling oil prices is likely to be that the Fed holds a bit longer at the current 2% fed funds target before trying to make a move in either direction.

Nor do I expect falling oil prices to bring relief to U.S. automakers. The fleet of U.S. vehicles is inexorably going to be converting to more fuel-efficient models as old cars get replaced, and that's a big challenge given Detroit's traditional market niche.

Source: WSJ.

But really the key question for purposes of assessing the economic consequences of falling oil prices is, Why did oil prices fall? To the extent that it is due to the increased global oil production that we've been anticipating ([1], [2]), that is unambiguously good news for an oil importer like the United States. But I'm persuaded that another key cause of oil's recent plunge has been economic weakness in Europe and Japan, which has meant both a stronger dollar and weaker global oil demand.

And weakness in global economic growth is a real threat to the U.S. economy. Exports are the one sector that seemed to keep the U.S. economy going in the second quarter. If you kick out the leg of a one-legged stool, prospects for stability are not too great.

Breakdown of U.S. real GDP annual growth rates.

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