The double whammy of rising oil prices and plunging home prices could turn a mild recession into something more threatening
In Charlotte, N.C., gasoline at nearly $4 a gallon is cracking "the survivors," as credit counselor Bruce G. Hamlett calls them. They're the people who played by the rules and kept up their mortgage and utility payments even as neighbors gave up and moved away, leaving empty homes. Now, crazy prices at the pump are pushing even these survivors over the edge. "They're asking, 'Do I put gas in my car or do I pay this utility bill or do I pay the mortgage?'" says Hamlett, director of economic independence for Charlotte's United Family Services. "It's getting to the point where it's an impossible choice."
For the U.S. economy, the twin shocks from oil and housing have become mutually reinforcing, potentially turning what may be a mild recession into something more threatening. Even those economists who think the U.S. might dodge a recession are concerned. Home prices are seemingly in free fall in much of the country. The Standard & Poor's/Case-Shiller National Home Price Index fell a record 14.1% in the first quarter from a year earlier, S&P reported on May 27. And now oil. After surging nearly 30% in two months, to $131 a barrel on the New York Mercantile Exchange on May 28, oil is twice as expensive as a year ago. "Up until now, housing has been the bigger story. Now I would put energy at potentially the same size," says James D. Hamilton, an economist at the University of California at San Diego.
It's enough to make a lot of people downright depressed. According to the Conference Board Consumer Confidence Survey released on May 27, Americans' expectations for the economy over the next six months hit their lowest point since the dark days of December, 1973—during a long recession triggered by an Arab oil embargo. Businesses aren't feeling exuberant, either. New orders for durable goods fell half a percent in April, the third decline in four months. Michael S. Hanson, senior U.S. economist at Lehman Brothers (LEH), expects the U.S. economy to grow at a slow 1.2% in 2008 and an even weaker 0.6% in 2009 as the headwinds from oil, housing, and the credit crunch continue.
A Painful Period of Adjustment
Given enough time, history shows, Americans can adjust to almost anything, from the demise of the family farm to the decline in factory jobs. In the long run, they can adapt to high oil prices by buying fuel-efficient vehicles or finding jobs closer to home. Likewise, with enough time, if they can't afford their homes, they can eventually cut a deal with their lenders or quietly move to a cheaper house or rental.
Trouble is, this ain't the long run. The one-two punch of rising energy prices and falling home prices has landed so quickly that many American families and businesses are breaking rather than bending. The evidence is the rapid rise in foreclosures, bankruptcies, and job losses. Actually, Charlotte is in better shape than most places. Home prices in the metro area were up slightly in March from a year earlier. Things are far worse in cities like Miami (down 25% over the past year), Detroit (down 18%), Phoenix (down 23%), and Las Vegas (down 26%).
The oil and housing woes are felt most heavily by the middle and lower-middle classes. The very poor are less affected because they don't own cars or houses, while the well-off have a cushion of savings and spare income to help them ride out the storm. Those in between have no such buffer.
On the business side, hardest hit are the sectors of the economy that are exposed to both rising oil prices and falling home prices. Detroit, for one. Automakers are being crushed because of falling sales of the gas-guzzling SUVs and pickups that, until now, made up the lion's share of their profits. At the same time, the housing bust has tightened credit conditions, making auto loans harder to get and cutting off the flow of home-equity loans, which many people use to buy vehicles. U.S. motor vehicle sales fell to an annual rate of 14.4 million in April from a total of 16.6 million units last year. Automakers can't do much about the credit squeeze, so they're focused on making more fuel-conserving vehicles. "This is a structural change, not a cyclical one," Ford Motor (F) CEO Alan R. Mulally acknowledged to reporters recently.
"A True Energy Crisis"
The twin blows of housing and oil are causing a headache for the Federal Reserve. Fed policymakers know how to deal with one shock at a time, but it's hard to devise a policy that addresses both at once. The housing bust is deflationary because it makes people feel poorer. That argues for easier monetary policy. The oil spike also makes people poorer, but it has an inflationary impact as well. On May 28, Dow Chemical (DOW) announced price increases of up to 20%, precipitated by what CEO Andrew Liveris called "a true energy crisis."
Ideally, the Fed would like to ease interest rates to get housing back on its feet and offset the deflationary effects of higher spending on fuel without making investors and the public worry that it's going soft on inflation. Says Mark Gertler, a New York University economist: "A lot of the discussion coming out of the Fed is aimed at shoring up credibility."
The risk for the Fed is that the economy gets stuck in slo-mo, but surging inflation expectations prevent the central bank from providing monetary relief. That could be bad news, especially if high gas prices soak up disposable income at the same time that Americans decide to save more to compensate for their abrupt loss of housing wealth. A higher savings rate is good for the U.S. economy's long-term health, though it would be deadly for short-run economic growth if it rose too suddenly.
It seems strange that oil prices are soaring at a time when the housing slump is killing economic growth. One explanation, of course, is that the appetite for oil is still strong in China and other parts of the world where growth is stronger. But even in the U.S., high oil prices have done little so far to suppress demand. That's because there's no ready substitute. People are consuming nearly as much gas now as when it cost half as much because they don't have much choice if they want to buy groceries and get to work. Meanwhile, production of oil hasn't gone up much, either, because companies are already producing flat-out from existing fields. The result is that the soaring price hasn't caused a glut, as you would expect if oil were overpriced. And that has emboldened speculators to keep bidding the price higher, testing what the market will bear.
Just Another Fact of Life
Gradually, though, the U.S. economy shows signs of doing what the textbooks predict it will, namely adjusting to higher oil prices. Airlines are starting to cut routes and raise fares, which is likely to reduce fuel use by simply discouraging air travel. With diesel even pricier than gasoline, some truckers are parking their rigs. Dan Little, president of Little & Little Trucking in Carrollton, Mo., hasn't driven since March and says he's spending his time trying to organize protests against the high price of diesel.
And gasoline consumption is finally starting to going down, albeit only slightly. That trend should continue as long as oil prices remain high. "In the last gas crisis in the 1970s we saw a tremendous ability to adjust," says Edward Glaeser, a Harvard University economist. In the long run, says Glaeser, "the car fleet is just very malleable."
Some sectors even stand to benefit from higher oil prices. American-made steel, for example, is becoming cost-competitive because of the high energy cost of shipping steel from places like China, notes Jeff Rubin, chief economist of CIBC World Markets. Says Rubin: "Now distance costs money."
Eventually, then, costly oil could become just another fact of life. As for housing, the fall in prices will make houses affordable to a new generation of buyers. Right now, though, it's hard to see past the pain.