Back in December I penned an article about the potential for gasoline prices to rise quickly to catch up with surging oil prices.  We said then "If we look at just the nominal price data going back to 1990 we can see that there is indeed a very high correlation between oil prices and gasoline prices.   While divergences from each other do occur on occassion those divergences tend not to last for very long with gasoline usually correcting towards the price of oil."   That is precisely what has happened since the near $3 per gallon of gasoline this summer, which was an effective $60 billion tax break for consumers during the much anticipated retail shopping season, to near $3.50 a gallon today.  That 16% rise in gasoline has now effectively wiped out the entire payroll tax cut being extended into 2012.

There has been a lot of media commentary as of late about the recovery in the economy.  The dangerous assumption being made here is that the recent upticks in the economic data have come primarily at the expense of inventory restocking and end of year buying of capital goods by businesses to lock in tax credits.  Extrapolating those bounces in the data well into the future can prove to be disappointing.  Yet this is exactly what the the President's current budget, which has been presented to Congress, has done.  That budget plans for 3% or stronger economic growth over the next 6 years.  This is a pretty lofty goal which considering last years growth was a paltry 1.7%.  However, in order to acheive a 3% plus growth rate the consumer is going to have to should 2.1% of that load through consumption. 

As we showed in our recent report on consumer spending and credit increases "...[The] recent increases in consumer debt are disturbing.  The rise in NOT about increasing consumption by buying more 'stuff' it is about just about being able to purchase the same amount of 'stuff' to maintain the current standard of living."  The rise in consumer credit is a function of the increases in the cost of food and energy on the consumer.  While the core consumer price index (ex food and energy) is tame at just over 2% the real impact to the American consumer is a combination of weakening incomes and rising food and energy costs as a percent of those incomes.  The chart shows the recent declines in wages and salaries versus the steady uptrend in food and energy costs as a percentage of wages and salaries.  The problem is the math - declining incomes + rising costs - lack of credit = weaker consumption and slower economic growth.

There have been quite a few theories as of late about rising oil prices whether it is a potential war with Iran or seasonal demand.  While part of the issue is the supply and demand equation - that does not account for the recent price surge.  As the world central banks have turned on the liquidity pumps to support the Eurozone and the U.S. economy; the most logical place for that excess liquidty to go is into highly liquid, highly leveraged, commodity contracts.  The rising number, the second highest peak on record, of oil contracts outstanding continues to push prices higher.  In turn those higher prices draw more speculation into the market - so forth and so on.  That is - until it pops. 

This is good if you are investing in oil and gas related stocks - it is bad everywhere else.  As oil prices rise so do the input costs to businesses.  Those costs have to be passed onto the consumer.  Currently, the consumer can do little to offset those increases other than by decreasing consumption.  The decrease in consumption leads to lower profits for businesses who in turn become defensive.  Since businesses have already cut permanent labor to the bone - the impact to profitability will be immediate.  The longer that oil prices remain elevated while incomes decline the more likely it is that the economy, which is already extraordinarily weak, will slow more than expected.

With Europe slipping into a deeper recession, which in turn will effect domestic corporate profitability, combined with rising input costs it is only a function of time until something has to give.  While the world, and the markets, are currently focused on the daily soap opera of "As The Greeks Turn" it cold be something as innocuous as food and energy prices that becomes the final straw for this camel.