March 5, 2008 — Gas and Groceries

Why higher gas prices might mean more crowded aisles at the grocery store
By Doug Campbell

Revised: March 17, 2008

Oil recently topped $100 a barrel and some analysts believe that gas prices could soon reach $4 a gallon. For consumers already facing uncertainty about their incomes, this potential energy shock comes at a particularly difficult time.

But the precise way that oil and gas prices affect consumers is a surprisingly rich source of academic inquiry. Some new research suggests that households are rather aggressive in finding ways to tighten their belts without making large sacrifices in their overall consumption levels.

The reasons to worry about rising energy prices are well-founded. Since World War II, a 10 percent increase in the price of oil coincided with a 1.4 percent decrease in economic output. In fact, oil shocks preceded five of the nation's last seven recessions.

The latest run-up in oil prices has been more gradual than oil shocks of past decades. Oil prices have climbed from about $20 a barrel in 2002 to $63 in 2006 to $102 a barrel as of Feb. 27, though there has been significant volatility along the way.

This years-long, gradual rise — as opposed to a quick, sustained spike — is one reason economists think that the standard oil-shock-portends-recession story hasn't unfolded yet. In fact, some economists believe the period known as the "Great Moderation" — during which economic output and inflation have been remarkably stable — can be explained in part because of the smaller size of oil shocks from 1984 to the present.

Consumers feel the effect of rising oil prices at the gas pump, but until recent years the relationship between gas and oil prices has been far from one for one. Economists with the Federal Reserve Bank of Cleveland reported that between 1986 and 1998, about 30 percent of the change in oil prices passed through to consumers in two months' time.

But since then, the pass-through has been 72 percent in a month's time. (The economists suggest that domestic oil refineries are no longer able to smooth changes in crude prices because they are running at full capacity.) The upshot is that, now more than ever, consumers are likely to quickly see the impact of rising oil prices reflected in gas prices.

Consumers today spend between 3 percent and 4 percent of their budgets on gas. Gas is a price-inelastic good, meaning consumers are more likely to look for other things in the budget to trim when prices increase. In a recent paper, economists Justine Hastings and Dora Gicheva with Yale and Sofia Villas-Boas with the University of California, Berkeley, document the way consumers alter their food shopping habits in response to gas price hikes.

Using data from the Consumer Expenditure Survey, the authors find that restaurant and takeout food spending falls about 50 percent for every 100 percent increase in gasoline. Meanwhile, grocery spending increases about 15 percent with every 100 percent increase in gas.

Overall, consumers save disposable income, but they are not necessarily eating less. In fact, the authors use scanner-level data from 180 West Coast grocery stores to show that consumers save further by buying discounted items when faced with rising gas prices. Instead of gourmet coffee, they may purchase on-sale Folgers.

The authors' back-of-the-envelope calculation is that consumers offset 70 percent of the hit from a doubling of gas prices in this fashion. "They can absorb the shock to their incomes by reallocating what they're purchasing instead of curbing their consumption," Hastings says in an interview.

But Hastings cautions that consumers probably aren't completely immune to rising gas prices. If prices continue to climb, we may reach a point where shopping for on-sale items is no longer a cure-all solution. Gas prices doubled during the period Hastings and her co-authors studied, from 2000 to 2005. What if they suddenly shot up further?

"Maybe gas prices have to go up a lot more to cause a recession," Hastings says. "If gas prices quadruple and I effectively lose 10 percent of my income, then it's difficult to imagine how you can keep consumption levels the same just by shifting to different products."

Related Links:
Gicheva, Dora, Justine Hastings, and Sofia Villas-Boas. "Revisiting the Income Effect: Gasoline Prices and Grocery Purchases." National Bureau of Economic Research Working Paper 13614, November 2007.