4 reasons to worry about rising oil prices

February 27, 2012

| MoneyRates.com Senior Financial Analyst, CFA

When financial officials from G-20 countries met in Mexico recently, there were many issues to discuss, but one of them leaped to the forefront: fast-rising oil prices.

Oil futures have surged to well over $100 a barrel recently, as a planned European boycott of Iranian oil threatens to squeeze supply. In response, Saudi Arabia has pledged to produce oil at its full capacity, and U.S. Treasury Secretary Tim Geithner said that the nation may deploy some of its strategic oil reserves to augment supply.

Is this a long-term rise in the price of oil, or just short-term speculation? A look at the price pattern in the oil futures market suggests it might be speculation. Higher oil prices are concentrated in contracts expiring over the next two years, with sharply lower prices thereafter. This suggests that traders don't have conviction that these higher prices are here to stay.

Regardless of whether it is simply a product of short-term speculation, the high price of oil has to be taken seriously. Here are four reasons why the economy is especially sensitive to the inflationary effect of higher oil prices right now:

  1. The U.S. recovery still needs to build momentum. Last year ended on an encouraging note, but this recovery has seen false starts before. GDP growth must continue to build, and then be sustained, in order for there to be significant progress in bringing down unemployment.
  2. Demand from Europe is likely to slow. The global economy is already facing a headwind in the form of austerity measures being put in place by a number of European economies to address their debt problems. Higher oil prices would represent an additional drag on global spending.
  3. Inflation is already ahead of savings account rates. Under normal circumstances, inflation would seem pretty mild right now, but in proportion to savings account interest rates, even 3 percent inflation is unusually high. For many people, these low savings account rates are sapping their incomes, and inflation is eroding the value of their principal. This isn't bad for only those depositors -- it also is draining wealth out of the economy.
  4. Americans need to balance spending and saving. Even without the European and oil challenges, the economy was already facing a pretty tough task. After years of chronically low savings rates, Americans need to reduce debt and build up savings, while still spending enough to keep the economy humming. That's a tall order, even without adding price and demand disruptions to the mix.

There is a feeling of deja vu about this, because oil prices also spiked in the early part of last year. That proved to be a speculative rally that didn't last, but it may have played a role in slowing economic growth in the first half of 2011. A repeat performance could prolong the agony of a painfully slow recovery.

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