Updated: Jun 10, 2022
Dear Clients & Friends,
Since we received great feedback from Dan’s article two weeks ago, we thought that we would go a bit deeper and discuss our near-term economic future. We also want to touch on gas prices - how could we not?!
The conversation about gas prices is fascinating because there is some psychology at play here. We’ve written many times in the past about behavioral finance, and we are currently witnessing an economic theory called “Money Illusion” play out as we observe prices at the tank. Peter Essele, one of our CFN analysts, wrote a great article about this only a few hours ago. We are shortening our GDP forecast notes in order to include his article below.
First, an economic update:
GDP is still expanding despite the pandemic, though not consistently across the different sections of the economy. We’ve been asked about a recession, and we think it’s possible, but NOT probable despite developments in Ukraine. The primary driver of GDP over the next few quarters is likely to be the pandemic. Trends have been positive in recent weeks, as the impact of the Omicron variant has peaked. The domestic employment environment is in better shape than it was a year ago, although consumer confidence trends are mixed. Auto sales have recovered from pandemic lows and are growing as the industry works to manage supply-chain issues. Businesses are expanding. The U.S. housing market has added to the economic recovery from the pandemic. Etc. Etc.
Metrics are good even though current events are depressing, to say the least. In addition, we mustn’t forget that the stock market is not the economy. The most recent decline in the market is due to the war in Ukraine. Obviously, the humanitarian impact warrants the vast majority of our attention. However, because this article is about the economy, it’s important to note that gas prices seem to be the only significant economic issue that the news is reporting on in regards to this conflict. We will discuss this further below.
Geopolitical tensions in Europe and a rising dollar will likely slow export growth. The Fed is poised to take steps to cool both inflation and the economy. Taking into account the Russian invasion of Ukraine, COVID trends, supply-chain issues, and inventory levels, the data suggests that GDP will grow up to 2% in 1Q22 (this number is actually lower than the figure that most research institutions are currently giving as their estimate).
Now… let’s talk about gas and the complexity of the human mind. Let me begin with an example. “I remember when [insert product] cost only [insert amount] but now it’s [insert amount].” Ever hear that? Ever say that?? Personally, I remember when a U.S. stamp cost 20 cents. I was 5 years old. Today, it costs 50 cents. Everyone seems to understand that the price increase is due to inflation. At the same time, gas prices were roughly $1.25. Today, we’re filling up at $4 a gallon. Would it surprise you to learn that, when adjusted for inflation, $1.25 per gallon in 1980 is equivalent to $4.14 today?
This is an example of the “Money Illusion” theory. Humans tend to think of money in absolute terms rather than in “real” terms, especially when considering the cost of societal staples like gasoline.
In regards to the price of gas, what we should really be looking at is the cost of gas per mile driven, which includes advances in fuel efficiency over the years, increases in income, and the effects of inflation. The cost per gallon is, to some extent, irrelevant if your car uses 25% of the amount of gas that it used to require, and we’re not adjusting the “real” cost after inflation.
Let’s take a deeper dive with our good friend Peter Essele.
Nominal Vs. Real Prices
The headlines and fears about all-time highs in gasoline prices are playing into an economic theory called money illusion, which is the tendency for consumers to view their wealth (and prices) in nominal terms rather than real terms. To think in real terms, it’s important to understand that the purchasing power of a dollar in March 2022 is not the same as it was in March 1992. Prices rise over time, so the value of a single dollar will decline over time as it buys fewer goods and services, all else equal.
Let’s walk through an example to illustrate what I mean. Let’s say your income in 1992 was $10,000 per year and the cost to buy a used car was $5,000. Over the next 30 years, both your income and the price of cars increase; in 2022, they are $50,000 and $25,000, respectively. In relation to your income, the cost of a car today is the same as it was in 1992 (one-half income). In real dollar terms, the cost to you has remained the same over the entire period, even though the sticker price of the car has increased over those 30 years. On the other hand, if your income had only increased to $40,000, the cost of the vehicle would’ve increased in real dollar terms because it would require a larger portion of your income.
Budgeting for Gas
Let’s apply the same logic to the cost of gasoline in today’s environment. Currently, the average price of conventional gasoline is about $3.50 per gallon. (This value most likely differs from what you see at the pump because it excludes state tax.) While $3.50 is a sticker shock, what should matter most as a consumer is how the price per gallon relates to income and how that compares to previous periods. That view offers a truer measure of the price in the context of purchasing power of the dollar, similar to the example above.
For a 20-gallon vehicle that requires a single fill per week, consumers need to set a weekly budget of $70 in today’s environment. Relative to the average American’s weekly income, $70 equates to about 6 percent of pay. In March 2012, the price of gas was $0.50 lower, and the cost to fill a 20-gallon tank was $60 instead of $70; however, incomes 10 years ago were also lower. In order to make a true assessment of where things stand today, we need to understand the ratio of gasoline prices to incomes over time. The results are shown in the chart below, which displays the weekly cost of gasoline relative to weekly income.
Source: Haver/Commonwealth Financial Network
It turns out that consumers needed to set aside a larger portion of their weekly wages to fill a tank of gas in 2012 than they do today (assuming mileage driven is the same). Ten years ago, consumers had to set aside a budget of almost 10 percent of weekly pay, while today it’s only 6 percent. It may feel like a tank fill-up is taking a larger bite out of budgets than ever before (as the headlines suggest), but the reality is we’re right around the 20-year average of gasoline prices relative to incomes.
More Mileage for the Buck
Another thing to consider is that most vehicles driven today are more fuel-efficient than they were a decade ago. So, chances are you’re requiring fewer fill-ups per month than you did in 2012. The chart below shows the average fuel economy of light-duty vehicles over time, with a 29 percent improvement in the period 2005–2020. As vehicles become more fuel-efficient, Americans are making fewer trips to the pump, and that means less money spent on gas over time even as prices rise.
Looking Beyond the Headlines
Our job as analysts is to help readers understand the numbers, which often includes looking beyond the headlines. In this case, it’s important to understand that while gas prices have increased recently, we’re not too far off from where we’ve been historically as it relates to budgets and the real cost of gasoline. Part of the reason we’re getting sticker shock these days is that we’ve gotten accustomed to paying very low prices in recent years. For the average American, the percentage of wages required to fill a 20-gallon tank of gas hit an all-time low of less than 2 percent in the depths of the pandemic. Now that prices have risen so dramatically in such a short period of time, it feels like things have never been higher.
In conclusion, I’d like to stress that the information presented here is in no way an attempt to diminish the very real difficulties that many households are experiencing in today’s inflationary environment. The numbers used above are based on averages. As we know, averages do not offer perspective on every situation. There are many households on fixed incomes that have not experienced an income increase over the past decade; thus, they have no additional income to help offset the increase in the price of goods and services. Also, there are individuals who have not had the luxury of trading up for a more fuel-efficient vehicle over the past 10 years. Those factors are very real. Our hope is that inflation reverts to a more reasonable level in the coming year in order to help ease the burden on those who are currently experiencing hardship.
As we part for the weekend, let’s keep our eye on the ball. As much pain as we’re experiencing at the gas pumps, or in consideration of stock market declines, the true pain is in Ukraine. Please let’s not let our local problems distract us from the humanitarian tragedy occurring overseas. MOR Wealth Management will be donating $10,000 to the Red Cross in support of humanitarian efforts in Ukraine. If anyone feels compelled to do the same, please click here. We’re all citizens of Planet Earth – therefore, we are all in this together.
Have a lovely and safe weekend.
Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC
1801 Market Street, Suite 2435
Philadelphia, PA 19103
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