As 1985 came to a close, Data Resources Inc. finished an economic forecast based in part on stable monetary policy, a cheaper dollar and crude oil costing $24 a barrel.
But suddenly oil prices plunged, spoiling the forecasts of DRI and many other firms. By January, DRI had revised its assumption for crude-oil prices to $22 a barrel, and the following week changed it again, said Roger Brinner, the firm's chief economist.
Now, to hedge its bets, DRI will use two oil price assumptions, one for $20 to $22 a barrel, and another at $17, which results in two very different outlooks for economic growth and inflation for 1986 and next year.
As forecasters restate their positions to account for lower oil prices, they find themselves edging closer to the Reagan administration, which predicts that the economy will grow by about 4 percent this year. Major private forecasters initially expected growth of less than 3 percent this year; now they expect it to exceed 3 percent.
Although many private economists are changing their forecasts, the Council of Economic Advisers will not adjust its outlook until March, a CEA spokesman said.
Oil prices have not been a significant factor to forecasters in recent years because they have remained relatively stable. However, a dramatic shift in oil prices affects costs for companies that use energy, consumer-goods prices, and general inflation -- and, therefore, interest rates.
It also affects corporate profits and the ability of companies to expand and increase their employment. Consequently, monetary and fiscal policy makers must take these shifts into account before determining what their policies will be.
The Blue Chip consensus of 50 economists this month raised its forecast for real gross national product -- the output of goods and services after adjusting for inflation -- to 3.1 percent from 3 percent, year over year.
The most pessimistic 10 economists in the survey boosted their average projection for growth this year from 1.8 percent in January to 2.1 percent in February.
"The drop in oil prices was volunteered by several as the major new factor on the favorable front," Blue Chip said.
"We have obviously upped our forecast a little bit," said Lawrence Chimerine, chief economist for Chase Econometrics. The forecast was not changed immediately, because the bulk of the price change was in spot market and future prices and not in contracts, which is how most of the oil is sold, Chimerine said.
Although most forecasters said economic growth would improve, they were not unanimous on the extent that oil price declines will affect inflation and interest rates, and on how the changes would take place. They also differed on how long and how far oil prices would drop and where they would stabilize.
However, they did agree that a lot depended on how the Federal Reserve Board interpreted the changes that oil prices would have on the economy and what subsequent measures were needed.
"In the short run, we're not quite sure how much a drop in the relative price of oil will boost activity," said John Maher, an economist with Citicorp Information Services.
Last year, average world crude oil prices generally ranged between $27 and $28 a barrel. Recently, however, oil prices on the spot market dropped below $16, lowering expenditures for many oil-importing developed countries and contributing to greater economic activity.
Chase originally expected economic growth of 2.2 percent for this year, and now has moved its forecast up to 3 percent, Chimerine said. Its inflation rate, measured by the consumer price index, was reduced from a little more than 4 percent to a little under 3 percent, Chimerine said.
Interest rates will drop slightly, because lower oil prices lead to lower inflation, which is instrumental particularly in lowering long-term rates, Chimerine said.
Chase Econometrics also still expects the Fed to ease monetary policy in the spring, despite the lower rates. But the easing would not be as much as it would have been before the oil price drop, now that stronger economic growth is expected, Chimerine said.
The trade deficit also will improve as lower prices of imported oil reduce the value of imports. The trade deficit should decline by about $15 billion this year for that reason alone, Chimerine said.
Citicorp is not changing its forecast much, because "we were one of the bulls for 1986" before the oil price decline, Maher said. Part of the problem is that it is unclear what the Fed will do, Maher said. For example, if the Fed is looking for economic growth between 3 and 3.5 percent, the Fed may not ease credit conditions to allow for lower interest rates and greater output, Maher said.
Citicorp has lowered its inflation forecast, which was based on a sharp drop in the dollar and an economy moving toward full employment. Citicorp had forecast inflation at an annual rate of between 5 and 6 percent by the fourth quarter of the year.
"Now, with the sharp drop in oil prices and prices eventually stabilizing," Citicorp pushed its inflation forecast down to between 4 and 4.5 percent at an annual rate by the end of the year, Maher said.
Citicorp also expects lower short-term and long-term interest rates because of lower inflation expectations and less reluctance by the Fed to tighten monetary policy because of the improved inflation picture. Before the oil price drop, Citicorp expected the Fed to tighten policy to keep inflation down, Maher said.
On the other hand, DRI said interest rates will be little changed because the bond market believes that the oil price decline is a short-term phenomenon that will not affect long-term rates, Brinner said. Lower prices could discourage conservation and drive prices back up. "This does not improve the long-term inflation outlook," Brinner said.
Also, DRI does not believe that the Fed will take any policy action in light of the oil price drop because it's not considered a long-term event, Brinner said. "The Fed is likely to wait and see," Brinner said. "I think the Fed might just say thank you" for the inflation improvement and leave policy alone.
A month ago, Wharton Econometrics reduced its oil price forecast from $24 a barrel to $18. "That's where we're assuming the trough is now," said David Berson, director of Wharton's quarterly model.
It consequently increased its forecast of GNP for 1986 from 2.8 percent year over year to 3 percent, and for 1987 from 3.4 to 3.8 percent.
Just about all of the change in the GNP forecast is due to the oil price decline and an expected increase in consumer spending, which is related to the price drop, Berson said.
Before oil prices plummeted, "We had assumed that, because of the very low savings rates, individuals would cut back on consumption," Berson said.
However, lower oil prices increase consumer confidence and therefore would result in a smaller drop in consumer spending.
How do lower oil prices increase consumer confidence? "If oil prices are expected to decline, then individuals are fairly confident that they're going to keep their jobs, their firms are going to do fairly well and their incomes will keep rising," Berson said.
However, changes in Wharton's interest-rate forecast hardly take notice of oil price changes, Berson said. The big factor there is another uncertainty making life more difficult for economists: the fate of the Gramm-Rudman-Hollings budget balancing act, Berson said.