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Why Oil Price Spikes “Feel” Worse

Written by admin | Jun, 8, 2013

oil_prices_versus_dpi_070811Today, more now than ever, we are barraged with economic data of which most is lost on the average person. One data point, however, that everyone understands is the price of oil as it directly impacts the average American where it counts the most, in the wallet. The price of oil cannot be escaped as it is plastered just about everywhere these days whether it is the current Administration admonishing oil and gas drilling companies, headlines in newspapers or on the internet and, ultimately, you see it at the gas pump.   Oil prices affect us every day in more ways than just what we are paying for gasoline, of course, it also affects everything that wear, consume or utilize from hard products to services due to rising input costs, fuel surcharges, etc.

This is one reason that when the government reports the consumer price index (CPI), and then strips out food and energy to report the core inflation index, it almost always elicits a negative response. This was evidenced by the response to Fed President William Dudley who got a street-comer education in the cost of living.  Back in March, on a Fed Reserve campaign to sell its monetary policy to “average Americans”; Dudley tried to explain that while commodity prices are rising other prices are falling. 

“Today you can buy an iPad2 that costs the same as an iPad 1 that is twice as powerful, you have to look at the prices of all things.”  

What he is addressing here is called “hedonics”.  Antony P. Mueller wrote a great piece on the “Illusions Of Hedonics” stating that “The Bureau of Labor Statistics (BLS) applies “hedonics” when calculating the price indices and for the computation of the real gross domestic product and of productivity.  The idea behind hedonics is to incorporate quality changes into prices. This way, a product may be on the market at a higher price, but when the product qualities have augmented more than the price in the eyes of the BLS, it will calculate that the price of this product has actually fallen.

Applying the hedonic technique to a host of goods and services means that even when prices were generally rising, but product improvement are deemed to be larger than the price increases, the calculated inflation rate will fall.  With a lower inflation rate, the transformation of nominal gross domestic product (GDP) into real GDP will render a higher result.  Likewise, given a constant labor input, productivity will increase. Hedonics opens the door to producing magical results: a lower inflation rate with generally rising prices, a higher growth rate although the economy may be weaker, and a higher productivity number, although productivity would have been declining without the hedonic imputations.”

It is important to understand this concept because this is why Bill Dudley was immediately lambasted by the reporters in the audience following his iPad statement with; “I can’t eat an iPad” and “When was the last time YOU went to a grocery store?”  

The reason that the “average American” can’t grasp things like “hedonic” adjustments to the inflation index, or even the idea of stripping out volatile food and energy components of CPI to get a core index, is because they live in a world where their daily lives are affixed to the disposable personal income they bring home. The average American gets a paycheck and then has to buy gas and food. In their mind why should you exclude the two items that are currently consuming almost 23% of their wages and salaries?

dpi_070811While there has been a lot of pandering about high oil prices, and ultimately high gasoline prices, what is more important to note is how do these price increases in oil “feel” to the average American.   The thing that the Fed misses, in my opinion, is that the average “American” is dealing with a lot rising cost pressures that aren’t necessarily included in the inflation calculation.   Furthermore, while prices of things like oil, commodities, college costs, insurance, healthcare, etc. have been rising; disposable personal incomes have been falling.   Therefore, each price increase that occurs has a larger and larger net effect on the limited amount of disposable personal incomes available to the consumer.   

This is why most consumer polls show that consumers “feel” like we are still in a recession.   To those individuals a recession is equivalent to not being able to make ends meet at home.   When the consumer is under pressure at home they tend to buckle day and reduce consumption. This is specifically why we are seeing such a lack of final demand from the consumer by small business which is keeping them entrenched in a defensive position and not hiring workers or expanding production.

The first chart above shows inflation adjusted oil prices over inflation adjusted disposable personal income and oil prices. Since oil prices are a direct input cost to so many different aspects of the daily lives of the average “American” price spikes in oil have a very real impact on the way that consumers “feel” about their ability to make ends meet.  

What we find is that when oil prices spike there is an immediate shock to the disposable personal incomes for individuals.   For example, during the Iran crisis oil peaked at $109 per barrel for consumers, however, it “felt” like $242 a barrel. Then at the peak of the oil market in 2008 when oil traded for $138 a barrel it felt much closer to $258 as real disposable incomes had declined.   Today, as oil trades around $96 a barrel consumers “feel” like it is closer to $139. 

This psychological “cost pressure” obviously impacts the way that consumers behave with their money and while the government tries to massage the differences in inflationary pressures to suppress adjustments to Social Security and Medicare; the average American is rapidly coming to grips that there is something entirely wrong with the state of affairs in the U.S. economy.   At some point the process of kicking the can down the road will meet its inevitable conclusion in this game of chicken as the process of deleveraging continues. As we stated in our recent post on “QE Was A Failure” the evidence is clear that Keynesian economics was a failure, not just recently, but over the last 30 years as increased monetary supply and lower interest rates have led to declining wages, savings and the dollar which in turn induced malinvestment.   The declines in income, which have been covered up by asset bubbles or through the use of leverage, is now beginning to weigh on the psyche of the consumer which is now mired in the middle of a “balance sheet recession”.

At some point the Fed may witness another type of deflation as the chant from the masses of serfs struggling to maintain a standard of living shrinks from “Let Them Eat iPads” to just “Eat This!”


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