(Illustration by Matt Mahurin.)

A more reasoned and productive approach relies upon the market to ultimately determine fuel prices. Market dynamics that balance energy supply with consumer demand, when combined with deft policy oversight from the Federal Reserve Board to address the macroeconomic consequences of price adjustments, will produce a stronger economy and a promising energy future.

Crude oil prices and government policies share equal blame for the current pain at the pump. Crude oil has jumped in price from $18 a barrel in January 2002 to more than $40 in 2004. As the global business cycle has heated up, world energy demand has increased faster than anticipated, notably in North America and Asia. The government also bears some culpability for current gasoline prices: Consumers pay roughly 50 cents in federal tax on every gallon of gasoline they purchase. Costly environmental regulations also add to pump prices.

In the United States today, energy and economy are inseparable. Gasoline facilitates most transportation services for both individuals and businesses, and represents more than 2 percent of consumer purchases. Consequently, its price helps form inflationary expectations. Sustained fuel price increases, therefore, bring about inflationary pressures.

As of May 2004, oil prices were roughly $10 higher than they were six months earlier. Global Insight finds that every $10 increase in the price of a barrel of oil (corresponding to 25 cents per gallon in the price of gasoline) shaves roughly 0.4 percent off of GDP growth. The 50-cent-per-gallon rise that took place between late 2003 and May 2004 drained about $5 billion per month from consumers’ pockets that could have been spent on other goods and services. This corresponds to a reduction of about 0.7 percent in consumers’ real disposable incomes—enough to make an impact on spending, especially at the low end of the market, where consumers are more likely to be cash-constrained.

What is more worrisome is that an increase in gasoline prices, in effect, redistributes income from consumers to crude oil producers. Over time, the producers will spend their extra income, but probably less rapidly than consumers cut back. And there is no guarantee that foreign oil companies will spend their newly found bounties on goods produced in the United States.

What governmental policy responses, if any, are appropriate? In making short-run macroeconomic policy in recent years, most central banks (including the Fed) have focused on the damage to growth that occurs when energy prices rise. Swelling gasoline prices typically lead to interest rates dipping lower than they otherwise would. Energy cost increases, however, also presage inflation, because these increases often pass through to other sectors. This can even lead to higher wage demands, raising the core (nonfood, nonenergy) rate of inflation.

The appropriate Fed response, therefore, depends on the circumstances. If rising gasoline prices are part of a larger story of rising price pressures driven by a fast-growing economy, then the inflation risks would tend to dominate—and the Fed would raise rates. Otherwise, the risks to growth would dominate, and the Fed would cut rates—or raise them more slowly than they would have.

If higher gasoline prices persist, consumers will find ways to economize the use of fuel, while producers will have an incentive to supply more. Yet, with no new refineries coming online in the United States in the past 30 years, changes to supply depend upon the choices of foreigners, many of whom are becoming increasingly hostile to the U.S. and its current energy policies. In light of this reality, addressing domestic demand by providing consumers with real choices in energy efficient vehicles is a more viable long-term solution. Offering more cars and trucks powered by fuel cells, diesel or natural gas would increase competition in the motor fuel market and the automobile industry. These market-based measures would be far more conducive to maintaining a strong economy and stabilizing gas prices than new government mandates would be.

Jim Osten and Nigel Gault are economists at Global Insight.