Out of Gas

As the national average for unleaded gasoline has spiked to around $3.77 a gallon, drivers are cutting back on their driving.  What makes this cutback in driving, compared to the previous price spike, and subsequent driving cutback, interesting is that it seems to have occurred prior to a cutbacks in other discretionary spending, such as clothes and entertainment.    In general, people are driving less while still buying more clothes, furniture, eating out more, and going to the movies more.

In the overall scheme of things, higher fuel prices are a drag on the economy.  Every extra dollar paid for a barrel of crude oil hurts the economy.  As pointed out in an article titled Moody’s: Effects of Rising Crude Prices are Immediate on the U.S. Economy, “The $18.50 increase in oil prices that we’ve experienced over the past couple weeks will, if sustained over the course of a year, cost consumers $20.4 billion just in higher home heating oil and diesel costs. It will cost consumers $46.3 billion in higher gasoline costs if sustained over a year. That’s equivalent to more than a third of the $120 stimulus that we got from the payroll tax reduction in the tax compromise last December.”  To minimize the effect of the higher fuel prices, the best place to cut back spending is on the fuel itself. 

The problem with cutting back on fuel usage is that fuel costs have risen over 20% and there is no way we can cut back fuel usage by that amount.  The silver lining is that, as a nation, we are addressing the higher fuel costs in a relatively good way by cutting back on fuel usage before cutting back on other spending.  Also, more and more people are making long term changes to how they consume fuel, such as gasoline, by switching to higher mileage vehicles, or improving the insulation on their houses.  With the current spike in price due mostly to a supply uncertainty premium, when things settle down and the price drops, we will have a lower base usage to move back to.

So why is the reaction to this price spike different from the last time?  There are several reasons, but first is “been there and done that”.   As a nation, we have been through this before and realized that cutting excess driving and changing the thermostat a couple of degrees was not as big of a burden as we feared.  The relative pain of driving a little less is not a bad as the pain of buying less of what we want   Walking to the store down the block or grouping errands is no big deal when it means you can still buy that new jacket.

Another factor is the economy is picking up.  More people are working as businesses slowly start to hire again.  If it was not for the local government layoffs, the job numbers would look much better.  The increase in private sector jobs has helped, in general, raise confidence in the economy.   

The improved outlook means that this time around higher fuel costs are a more isolated factor affecting our economy.  Over the past few years, many families did a good job of getting their household finances in order.  Many families greatly reduced their debt and ‘right-sized’ their consumption to be more in line with income and less reliant on debt.  In the past fuel price spike, consumers had to reduce their spend spending in addition to the reallocating more funds to fuel charges.  This time the reaction is more about targeted reductions in consumption.

At the end of the day, the U.S. is made up of consumers.  As the economy improves more Americans will feel comfortable with the relative debt, savings rate, and economic prospects.  This translates to consumers being more willing to consume.

When tensions in the Middle East dissipate, and the uncertainty premium on crude oil is reduced, we can hope that the current trend continues.  That the American consumer will maintain the cutback in fuel usage and use the subsequent savings in fuel cost  to either do more saving or spend it on something that helps the economy the most.  Of course, they used the savings to include more domestically produced items it would benefit the economy the most.