A summation of the September 14, 1990, meeting of the Fourth District Economists' Roundtable, at which panelists discussed the economic outlook in light of Iraq's invasion of Kuwait.Economic conditions - United States ; Iraq ; Petroleum industry and trade

John J. Erceg

Lydia K. Leovic

English

Research Papers in Economics

October 15, 1990
eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland
The Outlook After the Oil Shock
Between Iraq and a Soft Place
by John J. Erceg
and Lydia K. Leovic
M. he effect of August's oil price shock
on the U.S. economy was the main focus
of attention at the latest meeting of the
Fourth District Economists' Roundtable,
held September 14 at the Federal Reserve
Bank of Cleveland. The price shock
came at a time when the growth rate of
the economy was already sluggish and,
according to some analysts, moving
toward a recession. The 27 forecasters,
representing manufacturing, trade, and
financial institutions, predict sustained
economic growth through 1991, but they
also anticipate that higher oil prices will
cause a further slowdown over the next
few quarters. Participants also expect that
the inflation bubble that began in the
third quarter of 1990 will extend at least
into the first quarter of 1991.
A majority of the panelists believe that
the price of crude oil will average
between $25 and $30 per barrel through
the balance of this year, but revert to
$20 to $25 per barrel in 1991. Some
expressed the cautiously optimistic
view that no oil shortage will occur
during the fourth quarter. These partici-
pants believe that reduced demand
coupled with increased production by
some OPEC nations will compensate
for the net loss caused by the Iraqi/
Kuwaiti oil embargo. Additionally, no
shortage of petroleum products, includ-
ing gasoline and distillate fuels, is
expected this year. That outcome
assumes, of course, that there will be no
further disruption in the supply of crude
oil, especially from Saudi Arabia.
• A Pre-Oil Shock Recession?
The first issue confronted by Round-
table participants was whether the U.S.
economy was in a recession even before
the August invasion of Kuwait. Total
U.S. output (real GNP) has been rising
at an average annual rate of only 1.5
percent since the spring of 1989, which
is less than one-half the average annual
growth rate attained over the first six
years of the current expansion. A vari-
ety of other data for June and July sug-
gested to some business analysts that
the economy was indeed bordering on a
recession by early August.
What is a recession? According to one
business-cycle expert and Roundtable
panelist, it is a persistent and pervasive
contraction in economic activity. It is
not, as some commonly assume, simply
two consecutive quarterly declines in
real GNP. For example, the breadth and
depth of the economic contraction dur-
ing the first six months of 1980 were
sufficient to warrant a declaration of
recession by the National Bureau of
Economic Research (NBER), although
the decline in real GNP lasted only one
quarter.' On the other hand, real GNP
decreased in the second quarter of 1986,
and yet that episode (along with several
others that occurred during the 1960s
The Fourth District Economists'
Roundtable met last month to discuss
the economic outlook in the wake of
the Iraqi invasion of Kuwait. The
panelists expect a weaker economy
and more inflation for several
quarters, followed by a return to
more normal economic conditions.
Participants also discussed possible
monetary policy responses to the risks
of recession and higher inflation.
ISSN 0428-1276and 1970s) was not judged by the
NBER as constituting a recession.
Are current economic indicators signal-
ing a recession? According to Round-
table participants, the answer is not yet,
although it is admittedly difficult to dis-
tinguish between an economic slow-
down and a recession until well after
the fact.
The Composite Index of Leading Indi-
cators has remained relatively flat in
recent months, evidence of a continued
downturn in economic growth but not
of a classical recession, since no clear
decline has occurred. In addition, the
Diffusion Index of Leading Indicators
has been hovering around zero (rather
than below zero, as it does in reces-
sions), while the Composite Index of
Coincident Indicators is still positive, at
least through June. However, a slight
decline in the latter index occurred in
July (the latest month for which data are
available). The Long-Leading Index,
which correlates highly with GNP and
confirms the more commonly used lead-
ing index, did not suggest that the econ-
omy was in a recession during the pre-
oil shock period.
From these somewhat ambiguous indi-
cators, participants drew at least one
firm conclusion: The probability of a
recession has increased as a result of the
oil price shock.
• The Overall Outlook
Roundtable forecasters anticipate that
the effects of the oil shock may be only
transitory and predict that, although real
GNP will show no increase this half, it
will rise at a 1 percent annual rate dur-
ing the first half of 1991, followed by a
step-up in growth to 2 percent during
the second half of the year. The total
1990 increase in real GNP is projected
to be less than 1 percent, but between
1990:IVQ and 1991 iPVQ, the growth
rate should accelerate to 1.9 percent.
These anticipated growth rates repre-
sent a downward revision of the respec-
tive 2.2 percent and 2.7 percent in-
creases predicted by Roundtable
panelists last May.
Unlike other recent Roundtable meet-
ings, this one did not produce a strong
consensus regarding prospects for U.S.
economic growth. The spread around
the group's median GNP forecast is
much wider now than around the May
forecast. At least six of the participants
expect two to three consecutive quarter-
ly declines in real GNP, generally
beginning in 1990:IVQ and ending in
1991 :IQ. About half of the analysts
anticipate a decline in real GNP in
1990:IVQ, when the median forecast is
for total output to decline one-half of
one percentage point.
An alternative scenario calls for sus-
tained 2 percent growth in real GNP dur-
ing the last half of 1990, followed by a
1.5 percent increase during the first half
of 1991 and a 1 percent rise during the
second half of 1991. A panelist who
expressed this view believes that the oil
shock's effect on output will occur with
a lag of about four quarters, as busi-
nesses cut back investment in response
to energy price hikes. The inflation
effects, however, will be seen immedi-
ately. Consumer prices and the GNP
implicit price deflator (IPD) are expected
to surge between the last half of 1990
and the first half of 1991, before settling
down in the second half of 1991 to a
rate only slightly higher than preinva-
sion predictions.
• The Inflation Bubble
Roundtable participants widely agreed
that the effect of the oil price shock on
inflation will be sizable and immediate.
They were less certain about whether
those effects will be transitory or
longer term.
A bulge in the inflation rate is projected
to begin in 1990:IIIQ and to run its
course by next spring. The group's
median inflation forecast predicts an
increase in the IPD of about 4.6 percent
(annual rate) during the last half of
1990, which should continue into early
1991. However, as was the case with
output predictions, the inflation fore-
casts reflected more than the usual
degree of uncertainty. For the 1990:IIIQ-
1991:IQ period, the average quarterly
spread between the high and low
forecasts was 564 basis points. Fore-
casts of both consumer prices and the
IPD are considerably higher than predic-
tions made last May, partly as a result
of the oil shock, but also because of an
inflation rate that was rising even before
the August invasion.
From the spring quarter through at least
the balance of 1991, the median Round-
table forecast is for an average inflation
rate of about 4 percent (IPD basis),
which is slightly higher than the May
1990 projection. This upward revision
suggests that the effects of the oil shock
on inflation may not be entirely tran-
sitory.
• Consumer Outlook
How might the oil price shock affect
consumer spending? Even before the
Persian Gulf episode, real consumer
spending had been sluggish for several
quarters. One Roundtable panelist
asserted that the retail industry has been
in a mild recession since the spring of
1990. The immediate effect of the oil
shock was to jar consumer confidence,
but nonetheless, consumer spending has
remained at about preinvasion levels.
Retail sales in August were little
changed from the previous month.
Without relying on ususually large
incentive programs, domestic new car
sales held steady during August and
early September, nearly equaling the
January through July average. The short-
term outlook for non-auto retail sales is
cautiously optimistic, according to one
representative of that industry; however,
he noted that consumer income, wealth,
and confidence have been buffeted by a
variety of developments over the past
several quarters. Still, consumer con-
fidence is expected to rebound in time
for the holiday shopping season, and
consumer spending should follow suit.
Retail profits and profit margins also
are expected to improve in 1990:IVQ.• Manufacturing
In the two quarters preceding the onset
of the oil shock, manufacturing was
beginning to recover from a virtual no-
growth phase between the spring of
1989 and year's end. Because of rising
energy costs, panelists' views about the
short-term prospects for manufacturing
were mixed. The more optimistic out-
look is that a sizable pickup in indus-
trial production will occur by next
spring if the price of crude oil settles at
around $25 per barrel.
Roundtable panelists cited several eco-
nomic indicators that contribute to their
optimism. Going into this period of high
uncertainty, manufacturers have kept
inventories low relative to sales, unlike
during the 1980-82 oil shock episode.
Also, capital goods output should be
strong, supported by the transportation
and high-tech industries. Commercial
aircraft will be another major contrib-
utor to manufacturing growth, judging
by the industry's $2 billion order back-
log. Heavy-duty truck orders, perhaps
spurred by the higher fuel-emissions
standards mandated for 1991, have been
recovering gradually from a trough in
late 1989 and early 1990. August orders
were better than anticipated, despite
soaring fuel costs. In addition, public
construction (particularly for highways
and airports) and mining are still pockets
of steady growth.
Another cause for optimism is the vol-
ume of exports, which is expected to
grow between 6 percent and 8 percent
in real terms through the end of 1991.
The declining value of the U.S. dollar
against most major foreign currencies
has stimulated profitability in the export
market. The gap between the value of
merchandise exports and imports
(excluding oil) has virtually closed in
the last several quarters. In addition, the
trade-weighted value of the U.S. dollar
has settled to a low near the level
attained during the second half of 1980.
Less optimism about the prospects for
U.S. manufacturing was expressed by
other panelists. Foreign trading partners
are experiencing slower economic
growth, raising the potential for simulta-
neous worldwide recessions. Reduced
economic growth in the United States
and abroad would severely dampen cap-
ital spending, which is expected to lan-
guish for the next several quarters,
according to another Roundtable ana-
lyst. He noted a sizable, broad-based
weakening of export orders in August.
Overseas sales are still strong, however,
particularly throughout the Pacific Rim
nations, which are experiencing a con-
tinuing economic boom. Latin Ameri-
can business is improving as well.
Participants also voiced concern about
waning growth in the information-
processing-equipment industry during
the first half of 1990. This drop-off, evi-
denced by a weakened demand for parts,
is likely to parallel the downturn in the
overall economy. Exports of office and
computing equipment are good, but
domestic demand is increasingly being
satisfied by imported goods. Employ-
ment in the information-processing-
equipment industry has fallen, but this
slide has been offset by a rise in employ-
ment among office-product distributors.
• Monetary Policy Response
Roundtable analysts debated whether
the Federal Reserve should sustain its
anti-inflation policy goal in light of the
heightened risks of recession and
accelerating inflation caused by rising
energy costs.
One financial economist spoke in favor
of the Federal Reserve maintaining a
disinflation policy. In his view, the
long-term objective of the Federal
Reserve should be to keep prices stable,
which he sees as a precondition for
maximizing long-run economic growth.
He acknowledged that the economy is
weak, but believes that the core rate of
inflation, which he defined as unit
labor cost, is "poised to decline" if the
Federal Reserve does not accommo-
date the oil price shock. In his view,
the core rate of inflation should soon
decelerate because the growth rate of
domestic demand has been lower than
the "potential" growth rate of the over-
all economy.
This panelist was also guardedly opti-
mistic that the possibility for controlling
inflation is more favorable now than
during the two oil shock episodes of the
1970s. Even if the price of crude oil
increases to $30 per barrel (on a sus-
tained basis) from its pre-oil shock aver-
age of about $ 18 per barrel, he believes
that the inflation effects should be transi-
tory and should not become embedded
in expectations unless accommodated
by the Federal Reserve. Consequently,
he recommends no monetary easing,
since such a policy would only halt the
disinflation process. Moreover, even if
the economy entered an oil-induced
recession, output could not be revived
quickly because of the lag between pol-
icy actions and economic activity.
Another panelist urged that money
stock (M2) growth be increased rapidly
enough to result in a 4.5 percent to 5.0
percent growth rate by the end of this
year. That would be about the midpoint
of the 1990 M2 target range, and would
be consistent with the average growth
rate since 1987. In his view, a slower
rate of increase over the next six to 12
months, coupled with the effects of the
oil shock, would risk a recession. The
Federal Reserve would then be pres-
sured to take countercyclical actions to
revive output growth, even at the risk of
compromising its goal of price stability.
Other participants also raised concerns
about whether the Federal Reserve Sys-
tem should attempt to sustain an anti-
inflation policy in light of the recession
risk. Some cautioned that a recession
would have serious consequences for
the Federal Reserve and questioned
whether the System would be forced to
monetize the resulting enlarged federal
deficit. Others noted that a recession
would interrupt progress toward disin-
flation because economic recovery
would supplant price stability as the
main policy priority of the Federal
Reserve.Two other concerns about monetary
policy were also cited. The continued
rapid pace of price increases in the
service industry raised questions about
whether this sector of the economy is
insensitive to anti-inflation policies. It
was pointed out, however, that the
process of disinflation in this area is
underway, as illustrated by the indus-
try's drop-off in employment in recent
months. This decline should both
improve productivity and effect a slow-
down in wage growth, unit labor costs,
and, eventually, prices.
Some economists claimed that it is dif-
ficult to negotiate labor contracts that
do not reflect higher inflation rates, but
others argued that inflation-compatible
contracts would be unnecessary if wage
and price setters could reasonably expect
stable prices. Some participants com-
plained about labor and institutional
rigidities — supported by government
programs and legislation — that they
believe should be dismantled, prompting
others to agree that the federal govern-
ment has a legitimate role to play in the
effort to reduce the costs of disinflation.
• Summary
Before the oil price shock, Roundtable
panelists had already concluded that
economic conditions had been worsen-
ing since their last meeting in May.
Although the Persian Gulf situation
widened the range of both output and
inflation forecasts, on average the par-
ticipants expect the oil shock's effects
to be transitory. And despite the deteri-
oration in the short-term outlook, sev-
eral important sectors of the economy
should hold up reasonably well.
The oil price shock, hitting as it did
when the U.S. economy was already
weakening, has added a new dimension
to the outlook for output and prices. If
the Roundtable forecasts prove to be
accurate, that is, if output growth is
stronger in 1991 than in 1990, there
would be little reason to ease monetary
policy, even if following such a course
would have the expected positive short-
run effect on output. Acknowledging
the lesson of the 1970s, many Round-
table participants are concerned that if
the Federal Reserve were to ease mone-
tary policy, it would risk allowing the
oil price shock to spread more generally
throughout the economy in the form of
accelerated inflation.
• Footnotes
1. The National Bureau of Economic
Research (NBER) is the official arbiter of
expansions and contractions in the U.S.
economy. NBER bases its determination of a
recession on contractions in many economic
series—both financial and nonfinancial—
that occur at about the same time. Analysts
there have long rejected the sole use of GNP
to determine the dates of peaks and troughs
(expansions and contractions), even though
the NBER's designated dates often coincide
with GNP declines. See Victor Zarnowitz,
"On the Dating of Business Cycles," Journal
of Business, vol. 36, no. 2 (April 1963), pp.
179-99; and Geoffrey H. Moore, "What is a
Recession?" American Statistician, vol. 21,
no. 4 (October 1967), pp. 16-19.
2. For a discussion of the usefulness of lead-
ing indicators, see Gerald H. Anderson and
John J. Erceg, "Forecasting Turning Points
With Leading Indicators," Economic Com-
mentary, Federal Reserve Bank of Cleve-
land, October 1, 1989.
John J. Erceg is an assistant vice president
and economist and Lydia K. Leovic is a re-
search assistant at the Federal Reserve Bank
of Cleveland. The authors would like to
thank Gerald H. Anderson for helpful com-
ments on earlier drafts.
The views stated herein are reported by the
authors and are not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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The outlook after the oil shock: between Iraq and a soft place

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The outlook after the oil shock: between Iraq and a soft place

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