OIL PRICES WON'T BRING A RECESSION Yes, the economy is fragile, but pessimistic forecasters have learned the wrong lessons from the past. The jump this time doesn't compare with the earlier ones.
By Todd May Jr. CHIEF ECONOMIST Todd May Jr. SENIOR ECONOMIST Vivian Brownstein STAFF ECONOMIST Joseph Spiers RESEARCH ASSOCIATES Lenore Schiff and Lorraine Carson FORTUNE's forecast is produced by this magazine's economists using our own economic model.

(FORTUNE Magazine) – HIGHER OIL prices have raised simmering worries about the economy to a boil. The small band of forecasters who expect recession -- some say a downturn started last spring -- is growing and getting a lot of attention in the press. But the Middle East events that have raised uncertainty to nerve-jangling heights do not spell doom. FORTUNE's judgment remains basically the same as in our midyear 18-month forecast: Despite lots of slow-growth discomfort and nail biting, no recession before at least the end of 1991. Inflation will get worse -- but oil will be the least of the reasons. A common mistake is to draw the wrong lessons from the past. The 1973 and 1979 oil shocks that ushered in recession and inflation were much bigger relative to the economy than this one is so far. Many pessimistic discussions measure the $25-a-barrel U.S. price of imported oil reached in mid-August against the transient low of around $14 in July (see chart, next page). Instead, you should weigh the new prices against those that had been generally expected before the Iraqi invasion. FORTUNE was looking for close to $19 by the end of this year and $21 by the end of 1991. So the Iraqis have added about $5 to the cost of oil for the rest of this year and even less next year. Nothing is certain in the volatile Middle East, but the most prudent assumption is that once the promised additional production is pumped, the price will settle close to the current level, perhaps after going a bit higher before the increased flow has started. With U.S. oil consumption at 6.3 billion barrels a year, a $5 increase would add $30 billion to the cost of oil, the equivalent of 0.5% of nominal GNP. That will produce a much smaller jolt to inflation and growth than the increases in 1973-74 (2% of GNP), in 1979 and 1981 (1.5%), and 1980 (2.4%). The economy is weaker this time, to be sure, but that has its bright side: fewer excesses waiting to be corrected. For example, consumer spending was rising at a rapid 4% pace just before all the earlier crises. But having already slowed to a moderate 1% to 2% in the past year, it is now sustainable. Consumer confidence as measured by the Sindlinger & Co. index took a dive during the week of the invasion and the week after. Sindlinger has shown much the same trends in the past as the Conference Board monthly index of consumer confidence, but is usually more volatile, perhaps because it asks only about personal outlooks and has a changing sample. Even taking the drop at face value, the early August number is still above the lows of 1987, when consumer spending barely stumbled. Consumer attitudes will bear watching in the months ahead, but so far other measures confirm their relative buoyancy. Tandy Corp. receives daily reports from its 4,800 company-owned stores covering every city of 15,000 or more. Through mid-August, says Tandy Chairman John V. Roach, ''there has been no change in customer volume, unit volume, or purchase size.'' Sales of domestic cars dropped to a 6.6 million annual rate in early August from the 7.1 million pace for July as a whole, but that's no lower than many ten-day periods in the past few months. Homebuilding has shrunk from the excessive pace of a few years ago, and single-family starts may even recover some in the months ahead. Business spending for inventories, plant, and equipment is somewhat more problematic. With recession talk abounding, corporate officers could lean on the divisions to stretch out or delay capital projects. But they've heard dismal appraisals many times before during this long expansion without losing nerve. And mounting inflation will spur some investments before equipment costs go higher, especially when many manufacturing companies are striving to improve efficiency to meet tough competition. Note well: Manufacturing capacity utilization is still a mite above the average for the past 20 years and only marginally below last year's peak. The accumulated stock of plant and equipment, a rough measure of capacity for the whole private economy, is growing only 2.7% a year, compared with over 4% in 1973 and 1979. The increase is just about in line with average output gains expected over the next several years: no big correction needed here. So capital spending in real terms will at least hold steady over the next few quarters and likely rise a bit. An inventory cutback was already in the cards following the large buildup in the spring. In FORTUNE's survey of inventory policy taken before the invasion, business wanted a slower and more manageable pace but wasn't planning any liquidation. Here again, any fear of recession will probably be offset by anticipation of higher prices for purchased goods and materials, as well as for the goods sold. As accumulation levels out in the fall, growing final demand will lift output slowly. Thus real GNP will grow at a 1.5% annual rate or so this half. That's a half percentage point less than projected in our midyear forecast; the reason for the reduction is not just oil but also the Commerce Department's revision of earlier GNP data. The 1.5% pace will hold during 1991 -- only a slight improvement from the 1.2% of the past four quarters and well below the 2.7% in the year ended in mid-1989. The recession forecasters are still in the minority. The Blue Chip Consensus forecast following the invasion predicts nearly the same growth FORTUNE does for the rest of this year and even foresees a 2.1% gain during 1991. Five of the 48 forecasters now predict the two consecutive quarters of decline in real GNP that is usually cited as the definition of recession. But that definition is erroneous. Though most recessions include at least two such quarters (the 1980 recession had only one), the National Bureau of Economic Research, the official arbiter in these matters, examines a wide range of other figures in judging whether a recession has actually occurred and when. One clear victim of the new jitters is the budget summit. We never thought the conferees would enact the $50 billion package of tax increases and spending cuts they had talked about for fiscal 1991. At midyear $35 billion , seemed a more reasonable bet. Now $20 billion appears most likely -- and the $15 billion swing in fiscal stimulus will offset a good chunk of the drain of oil prices (only half of which will escape the country). FORTUNE expects the oil jolt to add no more than a half percentage point to the inflation rate this year, but then we were more bearish than most about the outlook before the fit hit Saddam. During the next few months inflation will probably reach an annual rate of 6% or more before subsiding. With profits already strained, many industries will pass along the costs before the year is out. So inflation in the broad GNP prices will average 5.2%, up from 4% in 1989. Next year flat oil prices, assuming no additional losses in production, will ease the pressure. But this year's rate will take a continuing toll, adding to the climb in hourly pay in 1991 and pushing companies to recoup these and other oil-induced hits on profits through higher prices. FORTUNE expects inflation at 5.5% next year, 1.5 percentage points higher than the current consensus. With inflation running at such a rate, the Federal Reserve won't be swayed by slow economic growth. Nor will it worry much about a moderately weakening dollar. Once Chairman Alan Greenspan has clear evidence of higher sustained inflation, he will tighten. Short-term interest rates have barely budged since the invasion -- investors have been parking their money while sorting out the prospects. As they do, short rates will rise -- next year they will be a point or so above the spring lows. Long-term rates have less far to travel. Yields on the 30-year Treasury bonds had climbed about a half percentage point by mid-month and should go up somewhat further in the months ahead. The increase will be limited because the Fed's tightening will show investors that it is serious about fighting inflation. Slow growth and tight money is a formula guaranteed to keep anxieties on a high plane -- but it beats any of the realistic alternatives.

BOX: OVERVIEW -- Inflation will climb to over 5% this year. -- Consumers will keep expenditures growing at only a moderate rate. -- Businesses will continue to lift capital spending.

BOX: FORTUNE'S BASIC OUTLOOK -- Growth: Real GNP will expand 1.5% during both 1990 and 1991. -- Inflation: GNP price increases will climb from 4% during 1989 to 5.5% in 1991. -- Interest rates: Next year they will be up a percentage point from the spring lows. %

CHART: NOT AVAILABLE CREDIT: Consumer confidence measured by Sindlinger & Co. CAPTION: STALWART SPENDERS Consumer confidence has taken a tumble, but not to a dangerous depth. Radio Shack customers are buying as before at stores everywhere, including this one in Torrance, California.