High oil prices shouldn’t be very inflationary, since inflation is already starting low, and there is plenty of spare capacity in the U.S. economy, according to a new reports from CIBC World Markets Inc. However, the report says gross domestic product will likely be hit by higher gas prices.

In the report, ecomomists Jeffrey Rubin and Benjamin Tal argue that “Given that the current capacity utilization rate is only 76.5%, and core producer price index inflation is running at only 0.7%, the starting point is promising, suggesting that once again, higher core producer prices will have little to no impact on prices of finished goods.”

They predict that the direct impact of oil on consumer inflation will take U.S. headline inflation to 2.5% by year-end. “But the clear disconnect between energy prices and core inflation, along with the inability of core input prices to lift the prices of finished goods, mean that core inflation will remain well protected, staying below 2% in both 2004 and 2005.”

Rubin and Tal note that consumer prices have become a lot less sensitive to oil price spikes. “A little over a decade ago, a 10% increase in energy prices would have raised the annual U.S. inflation rate by almost one and a half percentage points. Today, the same price shock adds no more than three-quarters of a point to the headline number.”

Previous oil shocks “proved to be the catalyst for an entire wage-price spiral that sent shockwaves through core inflation,” they note. “But that wage-price spiral that so challenged monetary policy makers two decades ago, has not been evident since the early 1980s.” The economy’s reduced reliance on energy is the principal reason for the much smaller pass through of rising energy prices to consumer price inflation rates, they note. Since the early 1970s, the final energy demand necessary to create a unit of GDP in North America has dropped by 50%, and the economy now is one-third less sensitive to oil price fluctuations than it was in the early 1980s.

The one exception to this lower-sensitivity to oil prices is gas pump prices. CIBC says that every 1¢ rise in retail gasoline prices eats up about US$1 billion dollars of personal disposable income in the US. So far, gasoline prices have risen roughly 30¢ this year. Rubin and Tal expect them to go another 10¢ higher, taking the total hit to household disposable income to around $40 billion.

“That is about one-quarter the annual gain in retail sales, enough of a hit to shave off half a percentage point from real consumer spending. Add this to the damage to corporate America via reduced profit/investment (due to a still limited ability to pass through higher input prices to consumers), and the recent hike in energy prices will end up chopping a quarter to half point from real GDP growth in each of 2004 and 2005.”