A Happy Coincidence?

Oil prices, already rising before Katrina, shot up further after the hurricane destroyed oil refining capacity in the Gulf Coast region. Oil price shocks affect both the supply side and the demand side of the economy. On the supply side, oil is an important input to the production of goods and services, and rising oil prices translate into higher production costs and lower output. On the demand side, gasoline expenditures make up a significant portion of consumer budgets and consumers may react to increasing gas prices by curtailing overall spending. Given the negative impacts on producers and consumers, you might expect rising oil prices to put the brakes on economic growth. Yet, the U.S. economy experienced strong growth even as oil prices increased during 2004 and 2005. Why have rising oil prices and economic growth coexisted so nicely?

Martin Feldstein, an economist at Harvard, sees a happy coincidence: a mortgage refinancing boom came along at just the right time, boosting consumption even as oil prices increased. Read his Financial Times column to see how refinancing might explain recent growth and why Feldstein is less optimistic about the economy weathering future oil price spikes.

Note: A mortgage is just a home loan. The collateral that secures the loan is the house itself--if you default on mortgage payments, the bank gets your house. Refinancing allows a homeowner to take advantage of a drop in interest rates by paying back his original high-interest loan with money from a new, low-interest loan. For example, suppose a homeowner borrowed $100,000 at 10% interest to buy a house, so he was paying about $10,000 per year in interest. If interest rates drop to 5%, they could take out a $100,000 loan from another bank at 5% interest, use that money to pay off the first loan, and thereby cut their interest payments to $5,000 per year.

The mortgage refinancing that Feldstein refers to in the article is called cash-out refinancing. Cash-out refinancing allows the homeowner to refinance for more than they currently owe on the house, and take the difference as a cash loan. For example, that same homeowner could have taken out a new loan for $120,000, used $100,000 to pay off the original loan, and kept $20,000 in cash. Their interest payments ($6,000 per year) would still be less than the original interest payments they were making, and they're able to increase their consumption by $20,000.

1. Saving is the portion of after-tax household income that is not consumed. When a household saves, it contributes current income to its stock of wealth. When a household borrows, it incurs a debt that reduces its stock of wealth. You can think of household borrowing as dissaving. How did the mortgage refinancing boom affect household saving? How did it affect household consumption?

2. How did most households use the cash they borrowed from mortgage refinancing? How did mortgage refinancing counteract the effect of higher oil prices?

3. What role did monetary policy play in the mortgage refinancing boom? How do the Fed's recent interest rate policies affect America's appetite for refinancing?

4. How does Feldstein describe today's global energy market? How do you think the U.S. economy would respond to another oil price shock?

Topics: Aggregate demand and supply, Oil price shocks, Monetary policy, and Mortgage refinancing