Why Hasn’t Cheaper Gas Created a Stronger Economy?

On the surface, the stunning drop in the price of gasoline at the pump — now down more than 57% since April 2011, and 39% in just the last seven months — should be a net positive for the U.S. economy.

After all, consumer spending comprises as much as 70% of the overall economy. With consumers saving roughly $700 per year in gasoline expenses, the additional discretionary income should, in theory, represent a huge boost to the U.S. economy.

And yet, GDP growth continues to grind along at a frustratingly slow pace. Meanwhile, interest rates have started upward, the labor force participation rate remains at a decades-low level and the Dow Jones Industrial Average is on the precipice of a bear market.

Why hasn’t cheaper gas translated into a stronger economy?

Consumers Delayed Spending Gas Savings

Two recent reports indicate what appears to be occurring with respect to consumer spending. Last May, Visa studied customer spending patterns and concluded that more than two-thirds of consumers used the gas windfall to pay down debt or beef up their savings. Five months later, JP Morgan Chase analyzed 25 million debit and credit card users and determined that a full 80% of the savings was being spent.

For quite a while, consumers were reluctant to spend the difference, skeptical that prices would remain low. As the months progressed, millions began to realize lower gas prices were here to stay and changed their spending habits.

At first glance, GDP growth during the final six months of 2015 didn’t mirror consumer activity, as GDP rose a modest 2.0% (annualized) in the third quarter and just .7% in the last three months of the year. However, solid gains in consumer spending were offset by weak exports and lower government outlays, masking the benefits of cheaper gas. With government outlays expected to increase next year and assuming exports manage to level off, GDP growth may finally reflect consumer spending in future months.

The Period of Low Interest Rates is Ending

The Federal Reserve deployed extraordinary monetary policy to fight the devastating impacts of the Great Recession. In doing so, interest rates were driven downward to record lows, hovering at or near rock-bottom for almost seven years.

One of the Fed’s primary missions is to ensure that inflation remains under control. With the U3 unemployment rate falling to 4.9% and the U.S. ticking ever-closer to the traditional definition of full employment, there is a danger that wage increases will cause inflation to spike. In concert with higher wages, increased spending from cheaper gas will put additional pressure on the prices of goods and services.

Thus, the Fed initiated a preemptive strike against inflation by allowing the federal funds rate to increase by 25 basis points last December, the first such increase since 2006.

The Labor Force Participation Rate is in Long-Term Decline

Much has been said over the past year about the sagging labor force participation rate. In January, it improved slightly to 62.7% but remains a hair above its lowest level in 38 years.

According to the Bureau of Labor Statistics, the reasons for the negative trend are as follows:

• The aging of baby boomers
• A slow decline in working women
• More young people are going to college
• The slow economic recovery

The first three bullet points are long-term structural changes within the economy that are projected to continue for at least the next decade. The final point — the economic recovery — has the potential to reverse itself relatively soon. If cheaper gas prices ultimately lead to ever-stronger consumer spending, the declining trend should slow.

Oil Is a Barometer of the Overall Economy

The intractable laws of supply and demand are the chief culprit for oil’s plunge on the spot market. When prices fall significantly, it means there is either excessive inventory or lower worldwide demand (or both). As a result, concerns over a slowing global economy rise, and continue to do so as time goes by. China’s economic struggles are a spectacular example of this phenomenon.

These concerns manifest themselves most visibly in the equity markets. Fears over a slowing world economy drive investors out of riskier assets like stocks and into safer havens such as bonds, or in the case of severe downturns, cash.

In recent months, consumer spending increases from lower gas prices have been overshadowed by worries over the health of the broader economy. As a result, investor flight has driven the Dow and other major markets into near-bear market territory.

2016 Will Tell the Tale

Rough winter weather depressed first-quarter GDP growth in each of the last two years. The Bureau of Economic Analysis said last summer that “residual seasonality” was creating a bias in the numbers and announced they were taking steps to correct the problem. Due to changes in the calculations, first quarter results should be positively impacted.

Nevertheless, one of the keys to 2016’s economic growth remains consumer spending, which was clearly buoyed during 2015 by low gas prices. It’s likely to see further gains this year as more and more consumers become convinced that prices will remain low.

That’s assuming, of course, that the politicians don’t shock the system with an ill-conceived government shutdown or other major negative action. As Yakov Smirnoff once quipped, “The reason gas prices are so high is because the oil is in Texas and Oklahoma and all the dipsticks are in Washington.”

© Copyright 2016 Walter McLaughlin, All rights Reserved. Written For: Decoded Science