Oil Spike: Insult to Injury

This week's surprisingly steep U.S. interest rate cut should have eased pressure on debt-laden Americans, but as record-high oil prices stoke inflation fears consumers may get the worst of both worlds.

Betting against the mighty U.S. consumer is usually a mistake. Spending held up remarkably well in the face of oil price spikes in 2005 and 2006, and many analysts argue that Americans have grown accustomed to paying $3 per gallon of gasoline and won't be shocked into cutting back now.

However, the spike that took oil above $80 per barrel this week comes as consumers are already contending with fallout from the slumping housing market and tighter credit conditions, as well as rising costs for a host of everyday items like bread, coffee and even beer.

Sara Lee Corp raised bread prices by 5 percent this month, and warned it may have to hike them again because of high wheat costs. Starbucks Corp raised prices by an average of 9 cents per cup of coffee this summer. Beer maker Anheuser-Busch plans to raise prices early next year.

And while the Federal Reserve's one-half percentage point cut in the benchmark interest rate should lower the cost of carrying credit-card debt, the inflation worries have pushed up yields on the 10-year Treasury bond that most banks use to set mortgages, so home loan rates actually rose this week.

"It's clear that the cut in itself is not going to help the consumer very much, but the signal that the Fed is so willing to step in here is probably comforting to everyone in the economy," said Torsten Slok, director of U.S. economics at Deutsche Bank in New York.

CALM BEFORE THE STORM

Economists and the Fed usually prefer to look at inflation data without volatile food and energy prices, which are rarely good indicators of the longer-term inflation trends that the central bank aims to tame with its interest-rate moves.

Still, as Fed Chairman Ben Bernanke likes to say, people do eat and drive, so it's impossible to ignore the impact that food and energy prices have on consumer spending.

An extra dollar spent on home heating bills means one less dollar to spend at the mall, and since consumer spending accounts for more than two-thirds of the U.S. economy it is no wonder that many economists have begun trimming forecasts for economic growth.

The latest government data on inflation showed price increases generally benign, with the consumer price index dipping 0.1 percent in August.

But scratch below the surface and the picture is less rosy. The decline in August was largely because of falling gasoline prices, and economists say that trend has already reversed this month.

Stripping out energy, consumer prices were actually up 0.2 percent from July. On a year-over-year basis, they rose 2.4 percent excluding energy, reflecting a steep jump in food -- particularly dairy products -- and medical care.

The producer price index paints a similar picture. Overall, August PPI was down 1.4 percent from a month earlier, but take away energy and prices were up 0.1 percent.

If there is a silver lining, it is that historically oil prices alone have not been enough to cause consumer spending to slump. Goldman Sachs analysts estimate that if oil remains at $80 a barrel and gasoline costs $3.00 at the pump, it would shave $32 billion off retail sales in 2008, or a modest 0.7 percent.

The bad news is consumers are coping with far more than just steep energy prices.

Goldman estimates that adjustable-rate mortgage resets and a drop in cash-out mortgage refinancing activity will erase $129 billion from retail sales this year -- more than 2.5 percent -- and another $100 billion in 2008.

"Swings in housing numbers will likely overshadow swings in energy prices," they wrote in a recent research note. "Only a shock scenario -- $100-plus oil, $3.50 gasoline -- could generate a spending drag approaching that of housing."

That's some small comfort. But then again, legendary Texas oilman T. Boone Pickens thinks it's only a matter of time before oil hits $100.

"You'll hit $100 -- I don't think you'll hit $100 this year unless you have some kind of geopolitical event that causes that to happen, but you're going to get to $100 at some point," he told Reuters this week.