from Energy, Security, and Climate and Energy Security and Climate Change Program

An Interesting Study on Energy Price Volatility

May 27, 2011

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Fossil Fuels

Financial Markets

Whenever I write about the economic problems posed by volatile energy prices, I inevitably receive a query from my editor: don’t I mean high energy prices? After all, people don’t really dislike volatility – they’re quite happy when prices fall.

Not quite. Volatility is, in itself, a problem. The Center for American Progress has an interesting report out today that explains why and backs that up with some useful numbers. Here’s the basic thesis:

“Large price swings for gasoline and other energy prices make it even more difficult for families, businesses, and ultimately the economy to plan for the future. Rising gasoline and energy prices should signal to families, businesses, and government policymakers that it is time to invest in energy efficiency and alternative energy sources. Higher gas and energy prices should lead to less demand and increased searches for alternatives. Yet the combination of high prices followed by increasing volatility quickly obscures these basic responses to higher prices.”

How does that show up in the economy? The CAP authors flag several facts. For example, high gas prices should get people to buy more fuel-efficient cars, but “there is a 73.1 percent chance that consumers will spend a below-average share of their after-tax income on vehicles after they have just experienced a period of high gasoline price volatility.” Similarly, while high energy prices should spur home upgrades, “Families’ investment in residential structures, which includes new home purchases and upgrades to homes, is on average 0.5 percent of gross domestic product lower than is typical, following high volatility”.

The study isn’t perfect. In particular, while the authors do seek out measures that won’t be confounded by price trends, they don’t take the obvious step of doing a statistical analysis that controls for prices trends explicitly. Nor is it comprehensive: among other things, volatility can mess with the economy through inflation, which can provoke problematic responses from monetary policymakers.

That said, the CAP study is useful, both in emphasizing that volatility is in and of itself a problem, and in putting some numbers on it. Expect more on the subject here soon.