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Oil, interest rates a 1-2 punch?
Current oil price hike may hit economy harder than '04 spike as rates also climb this time.
March 18, 2005: 4:15 PM EST
By Chris Isidore, CNN/Money senior writer
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NEW YORK (CNN/Money) - The United States rode out $55 a barrel oil last fall. But some economists say the latest jump in that key commodity poses a greater threat to the nation's economic growth.

Those economists say that the combination of rising oil prices and rising interest rates constitute a one-two punch for the economy that will be much harder to overcome.

Last September and October, as oil shot up more than 25 percent to $55 a barrel in less than two months, interest rates fell. The yield on the 10-year Treasury bond declined 6 percent during that time.

With that low-rate environment, the nation's economy grew at a 4.0 percent annual rate in the third quarter and a 3.8 percent pace in the fourth quarter, even in the face of rising oil prices and imports. That was much stronger gross domestic product growth than the 3.3 percent rate in the second quarter.

But the current spike in oil prices has come while the yield on the 10-year Treasury has been rising -- reflecting investor worries about a possible pickup in inflation. The yield, currently at about 4.50 percent, has jumped 13 percent since hitting a low of 3.98 percent on Feb. 9, while crude oil has climbed about 24 percent in New York.

"I don't necessarily think it'll be a knockout punch, but it'll deliver a blow to economic growth in 2005," said Rich Yamarone, economist at Argus Research.

The warning signs come when a number of new economic projections show an improving outlook for growth in 2005. And some analysts still believe the economy is resilient enough to grow faster, even in the face of the oil and interest rate pressures.

"Growth is more likely to firm modestly from here and it's quite unlikely to ease much further," said Anirvan Banerji, director of research for the Economic Cycle Research Institute. He said 5 percent GDP growth might be out of reach but he would expect better growth than at the end 2004.

But other economists say that rising oil prices and interest rates pose a serious threat that has brought about recessions in the past.

"When we are going at 4 percent, it's difficult to fall all the way back to contraction. But we could definitely end up having slower growth," said Ohio Northern University professor A. F. Alhajji, an expert in energy economics.

Alhajji noted that oil prices have less impact on the economy than they did in the late 1970s and early '80s, during previous price spikes, because of the rapid growth of the service and technology industries, which consume less energy than traditional manufacturing.

But he said that the rise in oil and rates in 2000 was a major factor in the 2001 recession, proving the economy can't just shrug off high energy prices.

History any guide?

Dean Baker, co-director of the Center for Economic Policy Research, said that the disconnect between oil prices and interest rates seen for much of 2004 is an aberration. The rule in economic history is that rising oil prices raise inflationary concerns and feed higher interest rates, he said.

Yamarone and some of the economists expressing concern noted that one period when both interest rates and oil prices were rising was in the spring of 2004, a period that preceded the so-called "soft patch" during which economic growth slowed to rates below most economists' forecasts.

Yamarone said it's possible a new soft patch is already beginning. "If you look at economic data we've received since the beginning of the year, it's been definitively lower than consensus expectations in most cases," he said.

Baker estimated that if interest rates and oil rise modestly from this point, economic growth will slow to about a 2.5 percent growth rate later this year.

But another spike in oil prices or much higher rates could bring about an actual recession, especially if higher rates lead to a fall in home values, he added.

All of which will be on the Federal Reserve's radar screen when the central bank's policy-makers meet next week to make their next move on rates. Another quarter-point hike in short-term rates is widely expected.

Whether the Fed drops its 10-month-old pledge to raise its short-term rate target at a "moderate" pace has been the subject of growing debate of late on Wall Street.

For more on that story, click here.

For more on commodity prices, click here.

For a look at how rising oil and gasoline prices affect you, click here.

-- This is an updated version of a story that originally ran March 10.  Top of page


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