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Gasoline Prices Headed for $4.00 a Gallon

Prof. Peter Morici - 4/18/2007

Yesterday, the Labor Department reported that the Consumer Price Index rose 0.6 percent in March, thanks in large measure to rising energy and food prices. Energy prices rose 5.9 percent in March, after rising 0.9 percent in February. Colder weather in February ran down inventories and pushed up fuel prices in March. Food prices were up 0.3 percent, after rising 0.8 percent in February.

In March the core CPI consumer prices less energy and food rose 0.1 percent, after rising 0.2 percent in February.

Food and energy prices are quite erratic from month to month. These are much less affected by U.S. economic conditions and Federal Reserve interest rate policy than other segments of the economy. Consequently, Federal Reserve policymakers pay close attention to movements in the core index.

Since March 2006, core consumer prices have risen 2.5 percent, and the compound annual rate of change for the three months ending in March was 2.3 percent.

Core consumer price inflation remains above Ben Bernanke's target range of one to two percent a year, and relief from this inflation is not likely before fall of this year.

No Change Likely in Federal Reserve Interest Rate Policies

In March, gasoline prices rose 10.6 percent, as cold weather pushed up demand.

U.S. refining capacity and stocks are stretched thin by rising domestic demand and U.S. environmental policies, and pressures from export-driven growth and inefficient petroleum use in China make additional global supplies even scarcer. U.S. gasoline stocks are well below 2006 levels, and this summer the average price of gasoline could rise as high as $3.50 a gallon, nationally, and $4.00 a gallon in California. Currently the average price is $2.92 per gallon, nationally, and $3.35 in California.

Surging gasoline prices will push up sharply the broader indexes of consumer price inflation in April and May. This bolt of inflation may have Federal Reserve policymakers reaching for the stomach remedies in their medicine cabinets. However, Dr. Bernanke may be able to offer little more than a bland diet and bed rest.

Inflation hawks within the Federal Reserve will be vocal for action, but they can offer Chairman Ben Bernanke few effective options other than to ride out the situation. U.S. environmentalists and Democrats in Congress will not abide new refining capacity, and it cannot be brought on line quickly. Only radical adjustments in Chinese exchange rate policies and export strategies, which Treasury Secretary Henry Paulson and President George Bush are unwilling to accomplish, could quell pressures on global and U.S. energy markets. By giving China a pass on its undervalued yuan and export subsidies, the Bush Administration has significantly limited Federal Reserve capacity to affect energy prices and control broader measures of inflation. This situation is likely to get worse before it gets better.

Despite higher gasoline prices and the housing slowdown, consumer spending for non-energy items, including automobiles, is advancing. Home prices are still up 55 percent from five years ago, and stock market values are up about 16 percent from last August. The economy should be able to deliver first half growth in the range of 1.8 to 2.4 percent. However, if the Federal Reserve pushes up interest rates too soon it risks a recession.

The Federal Reserve will not likely be able to accomplish both moderate inflation and reasonable GDP and employment growth. Faced with choosing between instigating a recession or an inflation spiral it cannot much slow, the best policy course will be to do nothing.

These conditions will severely test Ben Bernanke's judgment, patience and communications skills, and prove to be the crucible of his tenure. What he says will be as critical as his actions. He must calm financial markets and define for politicians the true impediments to price stability and robust growth if he is to succeed.

Sooner or later Ben Bernanke must focus the Congress and Administration on the inflationary pressures and constraints on growth imposed by U.S. energy policies and Chinese currency, trade and energy policies. If he fails to do that and inspire meaningful responses, the tradeoff between inflation and slower growth may become intolerable. Federal Reserve policy options will grow less pleasant.

Look for no change in Federal Reserve interest rate policy before at least August, slow GDP growth to continue until mid year, and a continued surge in inflation. In the second half, growth should improve somewhat, but inflation will remain a significant problem and largely driven by China's growth and appetite for oil. Too much growth in China would drive up oil and other commodity prices and could cause stagflation in the United States.


Outlook for Stock Prices

Moderate growth and stable interest rates will further strengthen corporate profits and investor confidence, though continuing concern about inflation makes a bull run unlikely. Corporate profits will outperform the U.S. economy, as many large U.S. companies profit from growth in Asia. Those foreign profits will provide the legs under the large caps and support the broader market.

Recent adjustments in home prices should rein in speculation and cause major builders to rethink land acquisition strategies that contributed to housing inflation.

Ordinary investors should shift from buying bigger homes to buying more stocks. Also, concerns about valuations in China and other emerging markets should spark more interest in U.S. equities.

Overall, rising profits and stronger demand should push up stock prices.