Why the gas price surge is an economic threat

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The average Canadian household spends a paltry amount on gasoline, amounting to less than 5 per cent of total purchases in a typical year.

Even so, gas prices have a strong grip on the consumer psyche. Gas stations offer frequent reminders of prices – often from a 20-foot sign in bright lights. Radio stations warn listeners to fill up before costs go up a few cents a litre overnight.

Lately, the message is loud and unrelenting: Gas prices are galloping higher as the Russia-Ukraine war leads to a supply shock for crude oil. As of Monday, the average retail price (taxes included) for regular unleaded gasoline in Canada was $1.84 a litre, up more than 20 cents in just a week, according to data from Kalibrate Technologies.

More pressure is coming. The U.S. and Britain said Tuesday they are banning imports of Russian oil, which sent crude prices skyward yet again. The increases are adding fuel to inflation, which is already at multidecade highs in advanced economies, creating a tough task for central bankers looking to rein in lofty price growth.

The danger is that companies and consumers – who set prices and negotiate wages, respectively – come to think steep inflation will drag on interminably, making it even tougher for central banks to control.

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“We really see that consumers base their expectations of future inflation in part on their recent experience of actual price increases,” says Sohaib Shahid, director of economic innovation at the Conference Board of Canada. “And within that, we see that energy prices, including fuel and gas, and food prices, play a disproportionately large role.”

A 2020 paper by economists at the Federal Reserve Bank of Dallas found that gas price shocks may drive one-year-ahead inflation expectations, even causing them to become “temporarily unanchored.” They noted that the rise in household inflation expectations from 2009 to 2013 – a period in which oil prices rallied to more than US$100 a barrel – “is almost entirely explained by a large increase in gasoline prices.”

Before the Omicron variant of COVID-19 and the Russia-Ukraine war, Canadians expected an annual inflation rate of nearly 5 per cent in a year’s time, according to a Bank of Canada survey in the fourth quarter of 2021. They expected the rate to eventually ebb to 3.5 per cent over a five-year horizon.

The Bank of Canada, which raised its benchmark interest rate last week for the first time since 2018, has maintained that long-term inflation expectations remain well-anchored. However, in a speech on Thursday, Governor Tiff Macklem said price pressures are broadening, a “big concern” that could influence long-run views of inflation.

“The lesson from history is that if inflation expectations become unmoored, it becomes much more costly to get inflation back to target,” he said.

Inflation is already weighing on public sentiment. A consumer confidence index from the Conference Board fell substantially in February to its lowest point in 11 months, partly because of gas prices, the think tank said.

The recent surge in commodity prices will “reduce consumer confidence even further,” Mr. Shahid noted.

There is a body of economic research that shows consumer sentiment grows more pessimistic as gas prices rise. But those reactions differ by age bracket and region, according to a recently published paper from U.S.-based economists Carola Binder and Christos Makridis.

In particular, they found that Americans who lived through the recessionary oil crises of the 1970s were especially sensitive to changes in fuel prices.

If people “have really strong memories of gas prices rising during bad times, like the seventies, then they’re going to be more likely to view any gas price increase that they experience now as also a sign of bad times,” Dr. Binder, a professor at Haverford College in Pennsylvania, said in an interview.

People also tend to view rises in gas prices as permanent. For decades, the University of Michigan has asked consumers about their expectations of future gas prices and, generally speaking, a strong majority of respondents expect those prices to stay the same or increase.

“People just have this tendency to say that prices are going to rise,” Dr. Binder said. “Also, there’s this asymmetry where we notice price increases more than we notice price decreases.”

To be sure, the commodities surge has benefits for Canada, a major exporter of products with rapidly rising prices of late. Notably, Alberta has seen a remarkable turn in its finances, projecting a surplus for the 2022-23 fiscal year, mostly because of a sharp increase in resource revenues.

But for individuals, along with companies already facing higher input costs, the rise in commodity prices is a “net negative,” Mr. Shahid said. Ultimately, the situation could weigh on consumption – not only because higher energy prices would leave households with less cash, he noted, but because some products would become too expensive to purchase.

“Higher energy prices and higher food prices are not good for the average Canadian,” Mr. Shahid said.

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