Once upon a time the world was supposed to run out of oil, but then demand cooled off, fracking took off, and prices tumbled to under $70-a-barrel. (And could possibly fall even further to somewhere between $40 and $50).
It's a nice shock that should give the economy a nice boost. But how much of one? Well, it's hard to say, but it should mean more spending and lower interest rates than we'd have in a world where "peak oil" wasn't just another mid-2000s fad like Crocs. Here's what that means, specifically.
1. The simple rule of thumb is that every 1 percent increase in gas prices takes $1 billion out of consumers' pockets. That's money we would otherwise spend on clothes and couches, movies and meals out, and, let's be honest, smartphones. Lots and lots of smartphones. So lower oil prices, in other words, are like lower taxes—$75 billion worth, to be exact, according to Kris Dawsey of Goldman Sachs. And right in time for the consumer bacchanalia that is the holiday shopping season, too.
Now, the economic effects of this extra spending won't be huge, maybe 0.3 percent of gross domestic product, but they won't be trivial either. Especially if oil prices stay around $70-a-barrel, which, as Nick Butler argues, they certainly could as the shale gas revolution spreads and solar power becomes even more cost-competitive. (The investment bank Lazard calculates that, even without subsidies, solar and wind energy are already almost as cheap as coal and natural gas).
The only downside is that lower prices at the pump will lull people back into buying Hummers and other gas guzzlers that will offset some of this good news. But at higher fuel-economy standards will keep us from fully repeating our circa 2005 love affair with behemoth-sized vehicles that struggle to get double-digit miles per gallon.
2. But there's a less obvious way that oil prices hurt the economy, and that's monetary policy. Central bankers, you see, are supposed to ignore food and energy prices, because they're so volatile. It's better to focus on so-called "core" inflation, since it predicts future inflation better than the headline number. The problem, though, is that central bankers don't always do that. Sometimes they overreact to oil prices.
That, at least, is what a then-professor named Ben Bernanke found when he looked at how the Fed has responded to oil shocks. It turns out that it's not higher oil prices that hurt so much as the higher interest rates they cause. That's because the Fed has tended to raise rates when oil prices go up to fight inflation that also goes up—a double whammy for the economy. Higher oil prices already mean that consumers have less money to spend on the things we actually make, but the Fed's reaction to them makes it even worse by making it more expensive to borrow too. Even Bernanke got a little blinded by admittedly sky-high oil prices in the summer of 2008, as inflation fears made him slow to react to Lehman. (Although, to his credit, Bernanke didn't repeat this mistake in 2011 when he dismissed the mini-oil shock then as merely "transitory").
So the good news is that falling oil prices mean there won't be any more pressure than there already is on the Fed to start raising rates. If anything, as Reuters reports, it might mean that there's more pressure on the Fed to wait a little longer before lift off. Indeed, markets already expect that the first rate hike won't come until October 2015, a full four months later than the Fed has hinted it will come. That's what happens when inflation is too low, and doesn't show any signs of rising anytime soon.
More spending and lower interest rates. Not a bad economic formula if there ever was one. Thanks, Bakken!