Monetary Wisdom - October 2009

By Charlie Ragland

As consumers and small business retailers, we are constantly aware of the change in energy prices and its effect on consumer spending. We see the changes at the gasoline pump, hear discussions of rising raw materials prices, and see the increase in our energy bill at home.

In general, higher energy prices reduce the spending power of consumers. This tends to depress consumer confidence, which can have a major impact on flooring sales as consumers postpone future purchases and increase precautionary savings. When a consumer has to spend $60 to fill up a tank rather than $30—and probably several times a month—that’s extra money that can’t be used for a flooring purchase.

Consumer sentiment has tended to follow the price of gasoline. Consumer confidence in the economy dipped significantly earlier this summer, according to the Reuters/University of Michigan Surveys of Consumers. It fell to 64.6 in early July, down from June’s final reading of 70.8 and to the index’s lowest level since March. (However, it rebounded to 70.2 in early September). The survey’s authors said that consumers concluded that the economic downturn would last longer and their personal finances would not recover as quickly as they had previously expected.

Economist Ed Yardeni, president of Yardeni Research Inc., says this spring’s rise in oil and gas prices could be at least partly to blame for the fall in consumer confidence. Perceptions about current economic conditions and expectation for the future are very much influenced by the price of crude oil, and particularly by the price of gasoline. When the price of gasoline approaches $3, or goes above $3, it depresses things.

James Hamilton, professor of economics at the University of California, San Diego, says that the strong relation between gas prices and consumer sentiment continued as falling gasoline prices between June and September 2008 lifted consumer sentiment back up. However, the subsequent financial scares and credit problems in the fall introduced a very dramatic new dynamic, causing consumer sentiment to drop back down to the June 2008 lows by November despite plummeting gas prices.

At times the economy is subjected to an energy shock, similar to the $4 gallon gasoline prices the summer before last. Lutz Killian, a professor of economics at the University of Michigan, observes that large fluctuations in energy prices have been a distinctive characteristic of the U.S. economy since the 1970s. Turmoil in the Middle East, rising energy prices in the U.S., and evidence of global warming recently have reignited interest in the link between energy prices and economic performance.

Killian argues that disruptions to crude oil production alone don’t adequately describe the factors contributing to spikes in energy costs. Demand spikes and energy expectation shifts also play a large role. The surge in crude oil prices since 2002 has demonstrated that large and sustained increases in oil prices may be driven primarily by demand for crude oil, especially when the ability to increase crude oil production in the near future is limited. All major oil price shocks have coincided with capacity constraints in crude oil production and strong demand for crude oil. His research also found that precautionary demand shocks driven by expectation shifts, unlike other oil demand and oil supply shocks, may have immediate and large effects on the U.S. economy.

Energy prices fluctuate due to the supply and demand at three levels of production and distribution: crude oil, industrial commodities (intermediates, chemicals), and retail (gas).

The U.S. Department of Energy through its Energy Information Administration has published its latest forecast, which indicates the price of crude oil will continue to rise. As crude oil impacts the cost of many underlying factors in the economy, we can expect a general increase in consumer expenses.

It appears that energy costs will continue to increase for some time. The key is understanding how to plan for the continual rise in crude oil, raw material pricing, and overall energy impact. The focus may need to begin with consumer sentiment and its psychological impact on spending and saving. Consumers are being assaulted with increases everywhere and are less confident about their investment choices. Changes in consumer confidence can impact retail flooring sales significantly, so keep an eye on consumer mindset, and think of strategies that you can take to raise the priority of using your product to improve your customer’s lifestyle.

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