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INTRODUCTION

The world price of oil has dropped dramatically in recent months. Other things being equal, this decrease would be expected to improve substantially the prospects for economic growth and to reduce inflation. We do not recommend changing the CBO forecast at this time, however, since the partial effect of oil prices on the economy is highly uncertain and may be offset partially or fully by other factors. A change in the forecast would have to take into account the following factors:

• Uncertainty about the permanence of the oil price decline;
  
  
• The weaker-than-expected economy late last year and so far this year, and lower interest rates than expected;
  
  
• The effects of low oil prices on domestic oil production;
  
  
• The effects on the financial soundness of energy producers and their creditors, particularly banks lending in the southwestern United States and to oil-producing developing countries;
  
  
• The possible monetary responses to falling oil prices and other developments;
  
  
• The unfavorable impact on inflation and favorable effect on growth of the larger-than-anticipated decline in the dollar.

Thus an analysis of the economic consequences of falling oil prices that neglected other developments in the economy could be misleading. Moreover, it now appears that the partial effects of the lower oil price on the economy are likely to be smaller than would be implied by scaling up the effects reported in previous CBO analyses,¹ for four main reasons:

• The oil prices discussed in the previous studies were not low enough to have a significant effect on domestic production or exploration.
  
  
• The previous analyses assumed relatively small percentage changes in oil prices. Large price changes are likely to have less than proportionately large real effects, in part because of the disruption they can cause in financial and labor markets.
  
  
• The previous analyses presupposed an economy with considerably more unused physical resources and a higher unemployment rate than the recent CBO forecast (in March 1983, the unemployment rate was 10.3 percent).
  
  
• Many analysts expect an increase in oil prices this year or next. A price decline expected to be temporary, as this one may be, will have much smaller effects on activity than one expected to be permanent, as assumed in the previous studies.

Oil Prices

The price of oil for delivery in April is currently fluctuating in the range of $11-$14 per barrel, well below the $23.40 per barrel refiners' acquisition cost (RAC) assumed in the CBO forecast to be the lowest reached in 1986. The RAC is probably above the futures market price because contract prices move more slowly, but even posted prices for the West Texas Intermediate crude are already in the range of $14-$16 per barrel and will likely fall further if the futures price remains in its current range. Underlying the dramatic oil price decline are several factors:

• The unwillingness of Saudi Arabia to continue to support the price of oil at the cost of driving its own-export revenues sharply down, and the difficulty of persuading other producers to take the swing role now vacated by Saudi Arabia;
  
  
• The very low short-run elasticities of demand and supply of oil, which mean that relatively small supply changes can lead to extremely large price changes;
  
  
• Very slow recent growth in worldwide oil demand because of weak economic growth and conservation; and
  
  
• The development of new sources of supply since 1980, totaling about 4.4 million barrels per day, in response to high prices.

Many observers believe that the current low level of prices is temporary. While the short-run floor for the oil price, imposed by short-run marginal operating costs, is probably not reached until about $8 per barrel, even the current level of prices, if it persisted, would be likely to increase oil consumption and reduce production, particularly in the United States, by a substantial amount over a period of several years. If the Organization of Petroleum Exporting Countries (OPEC) and other producers can reach an agreement to reduce production, the price could rise quite soon--settling either in the neighborhood of $20 per barrel, which some analysts think meets Saudi Arabia's current desire for increased revenues, or $15 per barrel, which other analysts think is low enough to dampen both conservation efforts and the development of new oil sources and alternative energy sources. Achieving agreements to limit production will be very difficult, however, and one cannot rule out the price's remaining for a while near current levels or even falling further.

Other Recent Developments

Economic indicators have been somewhat weaker recently than CBO had expected. The most evident manifestation of this is the sharp rise in the unemployment rate to 7.3 percent, in part the result of layoffs in the oil industry. While one month's unemployment is a shaky foundation for an analysis of the current state of the economy,² it is supported by reports of weak non-auto retail sales and nondefense capital goods shipments and orders. Auto sales were strong through most of February, but have required sales incentives to support them and have weakened recently. Total worker-hours and industrial production also fell in February. Capital spending plans for 1986, according to the most recent McGraw-Hill Survey, have increased substantially but remain weaker than would be expected if GNP were to grow at the rate projected in the CBO forecast. The trade deficit worsened sharply in December and January. It is not clear whether this reflects increased import prices resulting from the fall in the exchange rate--the lower price of oil had not yet affected the January data--or a further worsening of real trade flows. Of course, not all indicators point to weak growth. The strongest signs are in residential and commercial (shops and offices) construction. But overall economic growth has not yet responded to the improved financial conditions and the fall in oil prices.

The relatively weak picture for the past two months follows a large downward revision, to 0.7 percent, of the estimate of real GNP growth for the fourth quarter of 1985. Thus it seems likely that the level of real output in the first quarter of 1986 is distinctly below CBO's forecast. However, the economic outlook is expected to improve, particularly in light of the decline in the oil price, in the value of the dollar, and in interest rates, so there is no reason at this time to revise the forecast downward.

Interest Rates. Both short-term and long-term interest rates are currently below the levels forecast by CBO for the first and second quarters of 1986. The effect of the larger-than-expected decline in interest rates depends on its cause. If it is the result of weak credit demands, it may simply indicate general economic weakness. If it results from improved inflationary expectations, or a slackening of monetary policy, it could help stimulate business and housing investment. CBO's forecast assumed higher levels of business investment intentions than currently reported. In other words, some further stimulus to investment is required to validate our current forecast.

Decline of the Dollar. CBO's projections assumed that the dollar would decline about 14 percent in calendar year 1986. The decline in the dollar has been even sharper than anticipated, however, and is now about 7 percent below our forecast for the second quarter of 1986. According to a rule of thumb that CBO has previously used, if the dollar falls by 7 percent, consumer prices might ultimately rise by between 0.7 percent and 1.0 percent. Continued declines in the dollar, relative to the CBO forecast, could offset a large part, or even all, of the reduction in inflation resulting from the lower oil price.
 

IMPACT OF LOWER OIL PRICES ON THE ECONOMY

The Congressional Budget Office has previously analyzed the partial effects on the economy of oil price changes.³ These analyses cannot be simply extrapolated to the current situation, however, for several reasons:

• The recent oil price decline is larger than those previously analyzed and, if it is expected to persist, is for the first time large enough to have significant effects on domestic production of and exploration for oil.⁴
  
  
• The 1983 study, in particular, was done when economic conditions were very different from today's, and unemployment was 10.3 percent.
  
  
• As noted above, many analysts expect that the oil price drop may be largely reversed.

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1. Congressional Budget Office, Economic and Budgetary Consequences of an Oil Price Decline--A Preliminary Analysis (March 1983), and The Economic and Budgetary Effects of an Expected Oil Price Decline (February 1985).

2. The rise in unemployment from January to February was probably affected by unusual weather--a very warm January and floods in February. However, these events do hot fully explain the increase. Unemployment rose sharply in oil-producing states and in the industrial Midwest. Moreover, manufacturing worker-hours, which would have been much less affected by the weather, also fell in February. This might imply either an improvement in productivity, which has been abysmal recently, or a slowing of output growth.

3. Congressional Budget Office, Economic and Budgetary Consequences of an Oil Price Decline (March 1983), and The Economic and Budgetary Effects of an Expected Oil Price Decline (February 1985).

4. The importance of oil production in real GNP, and hence the impact of changes in oil production on real GNP growth, were dramatically increased by the Commerce Department's rebasing of the national income accounts from 1972 to 1982 prices that occurred at the end of 1985. For this technical reason alone, estimates of the real effects of oil price changes should differ from those made before the rebasing.