01/26/2011 01:14 pm ET | Updated May 25, 2011

How Do Oil Shocks Cause Recessions?

There are many ways that oil shocks affect the economy, and none of them are good. As the prices of gasoline, diesel and home heating fuel rise, consumers' energy bills eat up a growing share of their after-tax income, forcing cutbacks in more discretionary areas of spending. The next thing you know, people are going out to restaurants a lot less, taking fewer vacations and buying fewer clothes.

Soaring oil prices also transfer billions of dollars of income from oil-consuming economies to oil-producing economies. Nearly one trillion dollars migrated from OECD economies to OPEC ones in the record run-up of oil prices preceding the last recession. Since savings rates in countries like Saudi Arabia, UAE and Kuwait are typically ten times what they are in major oil-consuming economies like the United States or Western Europe, the shift in purchasing power resulted in weaker global demand.

But by far the greatest impact that oil price shocks have on the global economy is the one they make on inflation and, hence, interest rates. This linkage is the means by which they have typically delivered a mortal blow to economic growth. Oil shocks have always given rise to growth-ending increases in interest rates as central banks are forced to respond to the inflationary fallout they leave behind.

The last recession was no exception. As oil prices soared from $35 per barrel in early 2004 to almost $130 per barrel in the summer of 2008, consumer price inflation in the US tripled to a rate of almost six per cent. It didn't take long before interest rates caught up to inflation and, in the process, blew up the massively over-leveraged subprime mortgage market and the economy with it.

But lest we'd forgotten, it was the massive rise in energy inflation, and an associated rise in food prices (more on that in future posts), that catapulted the Federal Reserve Board's federal funds rate from a nurturing one per cent setting in early 2004 to a level over five times that only a couple of years later. The rate of energy inflation rose from less than one percent to as high as 35 percent.

Oil prices caused the last recession, and oil prices will cause the next one as well. Energy inflation is already on the march. In fact, this time around oil prices are rising much earlier and much more rapidly than they did last cycle. Inflation is already running at nearly a five per cent rate in China; as oil prices go on to set new record highs, it's only a matter of time of before we see those inflation rates in North America and in the rest of the OECD.

And when we do, get ready for another oil-induced global recession.