Temporary Oil Price Changes Hold Back Consumer Spending

I came across an interesting article called The Elusive Boost from Cheap Oil, written by Sylvain Leduc, Sylvain, Kevin Moran, and Robert J. Vigfusson. The article is about the reasons why the steep decline in oil prices since June 2014 did not, contrary to predictions, lead to a strong increase in consumer spending in the U.S. Typically, lower oil prices lead to more money available for households to spend it elsewhere. While reasons such as weak foreign growth and strong dollar appreciation are more obvious, the authors are focusing on examining the hypothesis that market participants are viewing the oil price decline as temporary which in turn is the reason for a moderate growth in spending. To test this hypothesis, the authors applied learning models to the oil market and economic models to test households’ spending.

 

Spot Oil Price vs. Future Oil Price

Spot and futures prices of oil during the 1990sSpot and futures prices of oil during the 2000s

Since the early 1990s, the Economic Letter analyses the perceived persistence of oil price changes and the relation between the actual spot oil price and the future oil price. Analyzing the oil prices between the 1990s and 2000s, one can see that while real oil prices fluctuated between $40 and $100 per barrel, future oil prices remained relatively steady and leveled in at about $18 within two years. In fact, investors expected the real oil price fluctuations to be temporary. This trend can be observed until 2003. In 2005, however, real oil prices kept rising and hence, market participants adjusted their perception of future oil prices because the trend seemed to be more persistent. Both real and future oil prices increased to a peak of $150 per barrel in 2008. Due to the Great Recession in 2008, consumers’ assumptions on expected future oil prices changed and the price leveled in at $90 to $100. From analyzing this data, the authors concluded that with more information gained over time, investors gradually learn and correct their assumptions about the persistence of oil price movements.

 

Learning Models Show Consumer Perceptions

Futures and model predicted prices of oil

To confirm this hypothesis, the authors applied learning models to the oil market. These models almost perfectly match the movement of market participants’ future oil price perception and show that future oil price changes reflect net impact of temporary and permanent factors for consumers. Whenever real oil prices change, market participants consider both temporary and permanent components and make their rationale about expected future movements. One can also individually identify temporary and permanent factors for the oil price movement by using statistical models. Thus, by looking at the oil future prices two years ahead predicted by the model and the actual future prices, the model’s forecasted numbers are very accurate. The model correctly predicted a slow increase from 2000 to 2005, followed by rapid growth until the Great Recession in 2008 which lead to a steep decline in future oil prices. After this decline, the model correctly predicted a gradual rebound in the following years and a massive decline beginning in 2014. Hence, the learning model can be used to estimate the persistence of oil price changes. According to the model, market participants assumed that until 2013, oil prices were mainly driven by permanent shocks. After 2013, however, the model shows that market participants changed their perceptions and believed that oil price fluctuations are temporary which lead to a decreased perceived importance of permanent shocks for oil prices. This finding supports the initial reasoning that consumers perceive the decline in oil prices sine 2014 as temporary and expect it to reverse in the near future.

 

Consumer Perceptions Influence Consumption & Output

However, the authors also argue that investors’ perception of the persistence of oil price changes does not only influence future oil price but households’ consumption and output as well. To confirm this assumption, the authors used an economic model. In this economic model, some households were given full information about the persistence of shocks that affect the economy while others were not. Households without information about the persistence of shocks had to learn about these shocks over time when more evidence for the persistence was available. Hence, they first incorrectly perceived the shock as temporary and gradually adjusted their consumption over time. Households with full information correctly perceived the persistence of the shock and adjusted their consumption accordingly. By adjusting the model slightly, households’ perceptions of persistence of shocks matched the empirical evidence from the first model. By combining these findings, the authors concluded that households that incorrectly perceive the shock of oil prices to be temporary have a 30% lower consumption than households having full and correct information about a shock’s persistence.

By applying a learning model and economic model to the oil market and its market participants, the authors confirmed the assumption that the moderate consumption growth is due to investors and households perceiving the current decline in oil prices as temporary. This shows that households with less information are less and later convinced that their future income, despite decreasing oil prices, will increase. Hence, the economy will not grow directly but only over time, as households change their perceptions of the persistence of the decline in oil price and adjust their spending.

 

Source: http://www.frbsf.org/economic-research/publications/economic-letter/2016/april/elusive-boost-from-cheap-oil-consumer-spending/

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