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RECOVERY:
HOW FAST AND HOW FAR?
September 17, 1975

CONGRESS OF THE UNITED STATES
Congressional Budget Office
Washington, D.C.

PREFACE

Recovery:

How Fast and How Far? is the second in a

series of reports on the state of the economy that will be
issued periodically by the Congressional Budget Office.

keeping with CBO's mandate to provide nonpartisan analysis
of policy options, the report contains no recommendations.
It was prepared by CBO f s Fiscal Policy Division, under the
direction of Frank de Leeuw, Cornelia MotheraI, Alan
Blinder, and Nancy Barrett.

Alice M. Rivlin
Director

September 17, 1975

(in)

C O N T E N T S
CHAPTER I:

Introduction and Summary

Economic Projections

Alternative Policies

CHAPTER II: The Economy in 1975

Pri ces and Costs

Production and Demand

CHAPTER III: The Outlook

Key Assumptions

Projections, 1975-77

CHAPTER IV: Alternative Fiscal and Monetary Policies
Current Fiscal and Monetary Policy
PoIi cy AIternat i ves
CHAPTER V:

37
38
44

The Impact of Decontrol of Oil Prices

The Costs and Benef i ts of Decontro I

53
54

Effects of Decontrol on the Recovery

How Decontrol Affects the Economy

Assumptions Underlying the Analysis

Tax Offsets to Decontrol

(v)

CHARTS

Indexes of Food Prices, Fuel Prices, and Wages

Indicators of Demand for Labor

Lead i ng Indicators of UnempIoyment

Final Sales and Inventories in Two Recessions

Unemp I oyment i n Two Recess i ons

Housing Starts and Auto Sales in Two Recessions

Business Expenditures for Plant and Equipment
in Two Recessions

Actual and Potential GNP, 1972-77

(VII)

19
22
24

T A B L E S
1.

Projections of Inflation and Unemployment, 1975-77

Policy Alternatives:

Fiscal and Monetary Policies

Policy Alternatives:

Immediate Decontrol of Oil Prices

Economic Projections, 1975-77

Federal Outlays for Fiscal 1976

Federal Open Market Committee Money and Interest Rate
Targets in 1975

Policy Alternatives: Estimated Effects of Expansionary
Fiscal and Monetary Policies

Policy Alternatives:
ary Policies

8.
9.
10.

Estimated Effects of Contraction-

Estimated Effects of Decontrol of OiI Prices

Expected Refiners ! Acquisition Costs of Crude Oil Under
ControIs and DecontroI

(ix)
58-216 O - 75 - 2

CHAPTER I
INTRODUCTION AND SUMMARY
The U.S. economy is beginning to recover from its longest and
worst recession since the 1930s, but it is not at all clear that the
recovery will be sustained enough to carry the economy up the long
road to full employment. As of mid-September, these points about the
recovery warrant particular emphasis:
•

The economic signs point to rapid growth in production in
the fa I I and winter.

•

Renewed inflation, spurred by food and fuel prices, is likely
to accompany the recovery.

•

Rising food and fuel prices and tighter monetary policies
may retard or even thwart the recovery after the initial
rebound.

•

Even if production and employment continue to rise after the
initial rebound, the recession has been so deep that unemployment will remain high for some years.

Production and Employment. Optimism about the months immediately
ahead is based on recent advances in business sales and new orders,
coupled with rapid progress in reducing the inventories that piled up
during the recession. Inventory liquidation is not yet over, but
has progressed far enough for future advances in sales and orders
to be translated into higher levels of production and employment.
The decline in the unemployment rate to 8.4 percent in July and
August may in fact be an early response to the improved sales and
order picture.
Whether the expected strong improvement in production and employment continues beyond the next few months is uncertain. The current
increase in consumer spending may prove to be a temporary response
to the tax cuts and benefit increases enacted in 1975. Sustained
economic growth will require continuing strength in several areas of
demand—housing, domestic automobiles, other consumer goods, exports,
capital goods, or government purchases.
Prices and Interest Rates. An especially worrisome aspect of the
current economic situation is the danger of renewed inflation before
the recovery gets a strong start. The rate of inflation, after

(1)

slowing markedly early this year, has begun advancing again. The renewal of inflation is not a result of current pressures on capacity or
labor shortages; excess capacity and unemployment remain high and wage
increases have moderated from their high rates of mid-1974. Rather,
the recent spurt in prices is due primarily to special food and fuel
developments. Recent increases in interest rates have also contributed to rising costs.
Major uncertainties about food prices center on the extent of
Soviet grain purchases and the size of grain crops here and in Europe.
Uncertainties about the energy price situation center around the future
of oil price controls and the size of any additional oil price rise
by OPEC nations. If food and fuel price increases continue they will
not only hurt consumers directly, but may trigger a new round of
wage, cost, and price increases and retard or even abort the recovery
itself.
Economic Projections
The projections of inflation and unemployment through the end of
1977 shown in Table I are based on these assumptions:
•

a rise of 9 percent per year in food prices;

•

no decontrol of "old" oil, removal of the $2.00 tariff on imported oil and a moderate price increase ($1.50 a barrel)
by OPEC this falI;

fiscal policy conforming to the first concurrent resolution
on the budget; and

money supply growth at less rapid rates than those of this
spring, toward the targets of 5.0 to 7.5 percent per year
announced by the chairman of the Federal Reserve Board.

Through early 1976, the Congressional Budget Office (CBO) projects a rapid rate of recovery from the bottom of the recession. Beginning in mid-1976, however, tighter monetary policies and the impact
of higher prices are expected to retard the recovery. By the end of
1976, the projections indicate an unemployment rate in the 6.9 to 7.6
range—representing some 7 million unemployed persons—and an inflation rate of 6.0 to 7.5 percent. During 1977 the projections suggest
slightly less inflation and little or no improvement for unemployment.

TABLE I—PROJECTIONS OF INFLATION AND
UNEMPLOYMENT, 1975-77

General Price Index
(GNP deflator)
Index
1958 = 100
1975:11 (actual)

184

Percent Change
from a Year Ago
+9.9

Unemployment
Rate
(percent)
8.9

1975: IV

189 - 191

1976: IV

200 - 205

+6.0 - 7.5

6.9 - 7.6

1977:IV

210 - 220

+5.5 - 7.0

6.6 - 7.5

6.0 - 8.0*

8.1 - 8.6

^Percent change for 1975: IV is change from 1975:11 at an
annual rate.

Compared to the budget committees 1 estimates at the time of the
first concurrent resolution, the current CBO projections are similar
on unemployment and somewhat higher on inflation. Compared to its
last projections on June 30, 1975, CBO has become slightly more optimistic on inflation, due to changes in the assumptions about oil prices,
and also more optimistic on unemployment, due partly to the oil assumptions and partly to recent ecpnomic news.
AIternat i ve PoIi c i es
Alternative economic policies would lead to different projected
outcomes. Of the many possible combinations, CBO has analyzed an expansionary strategy of fiscal and monetary policies designed to speed
the recovery and a contractionary strategy designed to limit federal
deficits and reduce the rate of inflation. The projected effects of
these alternative assumptions are summarized in Table 2.
The expansionary option consists of a federal spending increase of
$10 billion and a tax cut of $15 billion (in addition to extension of
the temporary tax cuts enacted in 1975) both effective at the beginning of 1976, plus enough monetary growth to prevent short-term
interest rates from rising higher than in the basic projections. CBO's
analysis suggests that this strategy would reduce the projected unemployment rate by about 0.7 of a percentage point below what it would
otherwise be by late 1976 and by I.I percentage points, or about I
million workers a year later. All three components of the package
contribute to this reduction.
The cost of this strong recovery option in terms of additional
inflation shows up gradually over a period of years. CBO has made
estimates of the effect five years later, showing an inflation rate
some 0.5 to 0.7 percentage points higher than it otherwise would be;
that is, 5.5 or 5.7 percent if the rate would otherwise be 5 percent.
The contractionary strategy consists of allowing the temporary
provisions of the Tax Reduction Act of 1975 to expire, federal
spending $10 billion below the level specified in the first concurrent resolution, and a monetary growth rate low enough to keep shortterm interest rates at the same levels as in the basic projections.
The results of these policies, according to CB0 f s analysis, would be
an unemployment rate of 0.6 percentage points higher than in the
standard projection by the end of 1976 and 0.9 percentage points
higher a year later. The gain in terms of reduced inflation would be
an inflation rate 0.3 to 0.4 percent lower than it would otherwise
be five years from now.

TABLE 2—POLICY ALTERNATIVES:
MONETARY POLICIES

FISCAL AND

Expansionary Strategy

Tax

Spending
Component

Component

Monetary
Component

-.4
-.4

-.3
-.4

-.1
-.3

0
.2
.2

-.1
.1
.2

Three
Components

EFFECT OF POLICY ON:
Unemployment Rate
(percentage points):
1976:IV
1977:IV
Annual Rate of Inflation
(percent change, General
Price Index):
1976
1977
1980

0
.1
.2

-.7
-I.I

0
.4
.5 to .7

(continued)

TABLE 2 (continued)—POLICY ALTERNATIVES:
MONETARY POLICIES

FISCAL AND

Contractionary Strategy

Tax
Component

Monetary
Component

Three
Components

+ .3
+ .4

+ .2
+ .3

+ .1
+ .2

+ .6
+ .9

0
-. 1
-.2

0
0
-. 1

Spending
Component

Unemployment Rate
(percentage points):
1976:IV
1977:IV
Annual Rate of Inflation
(percent change, General
Price Index):
1976
1977
1980

EFFECT OF POLICY ON:

-.1

0
-.2
-.3 to -.4

Alternative energy policies could also cause significant changes
in the economic outlook. One policy which would both contribute to
inflation and retard the recovery is immed iate decontrol of oil prices,
The results of CBO f s analysis of immediate decontrol appear in Table
3. They indicate that by the end of 1976, decontrol would add 1.5
percent to the general price level and 0.5 percentage points to the
unemployment rate. By the end of 1977 the effects would have grown
to 1.8 percent for the general price level and 0.6 for the unempIoyment rate.

TABLE 3—POLICY ALTERNATIVES: IMMEDIATE
DECONTROL OF OIL PRICES

1975:IV

1976: IV

1977: IV

Unemployment Rate
(percentage points)

+ .1

+ .5

+ .6

General Price Index
(percent of GNP
deflator)

+ .5

+ 1.5

+ 1.8

EFFECT OF POLICY ON:

While there are many reasons for uncertainty about the future
strength of the recovery, there seems little doubt that the problems
of high unemployment and high inflation will continue to be with us
for some years ahead. The current unemployment rate is so high and
increases in the working-age population so large that not even a combination of expansionary fiscal, monetary, and energy policies is
likely to bring the unemployment rate close to its 1946-74 average of
4.7 percent during the next two years. And only a highly fortunate
combination of crop developments, energy price movements, and wageprice response to economic slack could bring the overall inflation
rate back to its 1946-74 average of 3.7 percent. The most likely
outcome is for relief from the extraordinary unemployment rates of
this spring but for continued coexistence of high unemployment and
high inflation.

58-216 O - 75 - 3

CHAPTER I I
THE ECONOMY IN 1975
The American economy is in double distress—suffering from deep
recession and severe inflation at the same time. In recent months prospects for recovery from recession have brightened. In the immediate
future, increases in production and reductions in unemployment seem
highly probable. At the same time—and apparently coincidentally—the
outlook for inflation has worsened. If the price increases of the last
two or three months continue, hopes for a respite from inflation will be
dashed, while recovery from recession may also be endangered.
Prices and Costs
After an encouraging slowdown of inflation during the first half
of 1975, prices suddenly leaped up again at the beginning of the summer. The Consumer Price Index rose at a monthly rate of 0.8 percent
in June and an additional 1.2 percent in July, bringing the annual
inflation rate for those two months to 12 percent. The Wholesale Price
Index rose at a distressing 13 percent annual rate during July and
August.
The new surge of inflation is caused largely by increases in food
and fuel prices. Excluding food and fuel the Wholesale Price Index rose
at an annual rate of only 3 percent in July and August. Average wage
increases have been moderate in- recent months and the productivity gains
that are typical of the early stages of a recovery are further reducing
the effect of wage increases on total costs. If food and fuel prices
continue to rise at their current rate, however, they are likely to push
wage increases up and to trigger a new round of increases in costs and
prices.
The prices of food and fuel have fluctuated wildly in recent years
(see Chart I); thus history provides little basis for predicting whether
the current upsurge is a one-shot phenomenon or the beginning of a new
and dangerous round of inflation. The dramatic increases of 1973 and
1974 were a major cause of double-digit rates of general inflation in
1974, one of the big unexpected economic shocks of recent years. Largely
unrelated to the current demand situation in the United States, such inflationary shocks at first added to inflation and then, by reducing the
real incomes and wealth of most households, contributed to the subsequent recession.

CHART i —INDEXES OF FOOD PRICES, FUEL PRICES
AND WAGES (1967 = 100)

260
Whole sale F j e l
Price s

240

/
/

220
Wholes ale Fc od
Prices

200

;
1 •

180

\
41

1
$

}

160

140
Hour y Wage
i

120

100

67
Source:

Bureau of Labor Statistics.

11
Another cause of the inflation of the early 1970s, only partly related to domestic economic conditions, flowed from successive devaluations of the dollar in 1971-73. Still another upward force was the development of inflationary expectations, based on the gradual acceleration of prices during the 1960s. Once firmly held, these expectations
played the role of a self-fulfilling prophecy in product, labor, and
other market negotiations. Businesses and workers take into account
future price rises they expect when they negotiate wage settlements;
inflationary expectations also influence price setting, speculative
buying of materials, and interest rates.
Early 1975:

Inflation Receding

Early in 1975, almost as unexpectedly, the inflation outlook began
to improve. The most dramatic evidence came from the "GIMP deflator," a
comprehensive index of prices of all final goods. This index, which
had risen by more than 10 percent from 1973 to 1974, slowed to an annual
rate of 8.4 percent in the first quarter and only 5.0 percent in the
second quarter. These rates of increase still are well above the average rate for the entire span from 1946 to 1974 (3.7 percent per year),
but they are far short of the double-digit increases of 1974.
The overall Wholesale Price Index actually declined from November
to March. This was the result of two offsetting trends. Farm and food
prices fell sharply, while the more important industrial component rose
slightly. Within the industrial total, the fuel and power component
rose no more than other industrial commodities. Thus food and fuel,
two leaders in the 1973-74 inflation, were no longer adding to the rate
of inflation in the early months of this year.
A slowing of wage rate increases also contributed to the lessening
of inflationary pressure, although not as early as food and fuel prices.
Hourly compensation in all nonfarm industries, after rising at an annual
rate of more than 9 percent during 1974 and early 1975, slowed to an
annual rate of 7.8 percent in the second quarter of this year. It might
have been expected that unemployment rates in excess of 8 percent would
have brought wage increases down to an even lower rate. Recent wage increases, however, have been barely sufficient to keep up with rising
prices; and as long as there is general expectation of continuing inflation, significantly lower settlements in labor negotiations seem unlikely.
A final contributor to the slowdown of inflation was the resumption
of growth in productivity in the second quarter as the recession reached
its worst. This is typical of an early recovery period when businesses
have more workers than they need, especially in supervisory and central
office functions, and can expand output with less than proportionate increases in hours worked.

12
Mid-1975:

New Inflationary Pressures

At mid-summer considerable optimism about inflation seemed justified. Food and fuel prices were no longer escalating. Wage increases
were slowing under the impact of high unemployment, and further productivity improvements could be expected as recovery proceeded. But optimism about the inflation situation ended abruptly with the release of
the June Consumer Price Index in late July and the July Wholesale Price
Index early in August. While one or two months 1 rates of change should
not be taken as establishing a new trend, an examination of the sources
of the recent increases does suggest a distinct danger of inflation
ahead.
Once again, the most dramatic changes were in food and fuel prices.
The food component of the Consumer Price Index rose by 1.5 percent from
May to June and by 1.7 percent from June to July (seasonally adjusted),
after a rise of only 0.5 percent in each of the previous two months and
declines before that. Wholesale farm and food prices in August were
4 percent above June, after declining on balance over the previous six
months. Wholesale fuel prices rose by more than 6 percent from May
through August. Further increases can be expected if oil prices are
decontrolled and if OPEC countries raise the price of imported oil.
Food Prices. A major factor in the rise in wholesale farm prices
has been grain purchases by the Soviet Union in world markets. These
have been estimated at 14 million to 15 million tons so far this year,
and are expected to reach 25 million tons. Grain production in the
Soviet Union is highly variable. Consequently in some years the Soviet
Union buys very little grain in world markets and in other years considerable quantities. The impact of this variation on grain prices has
increased since the depletion of stored grain stocks in this country.
In addition, adverse weather conditions in the western part of the
U.S. corn belt and in Europe, are contributing significantly to higher
prices.
None of these influences is responsible for this summer's increase
in food prices at the retail level, as opposed to the farm and wholesale
level. Recent increases in consumer food prices have been led by a
sharp increase in meat prices, which in turn can be traced to high grain
prices last fall. The chain of events began with poor weather last summer, a reduced harvest last fall, and high grain prices at that time.
High grain prices mean high costs of producing livestock, which increases
the price of meat, to some extent right away but largely after a time
lag. As the influence of last year's poor harvest recedes, retail food
prices may drop somewhat from current levels.

13
Food prices, in short, are buffeted by complex and largely unpredictable influences. Recent inflationary influences have caused the
Department of Agriculture to revise its estimate of the increase in
1975 consumer food prices from 6 percent over 1974 to 9 percent. Current developments in world grain markets probably will contribute to
further rises in consumer food prices next year.
Fuel Prices. One factor pushing up the price of gasoline and other
petroleum products has been the special import duty of $2.00 per barrel
on crude oil imposed in two stages by the President on February I and
June I. In addition to raising the price of imported oil, these duties
indirectly push up the price of producing the roughly 40 percent of
domestic crude oil that is not subject to price controls. Eventually,
each $1.00 of import duty would be expected to raise the price of about
60 percent of U.S. crude oil consumption (30 percent imported and 30
percent uncontrolled domestic) by a full dollar per forty-two gallon
barrel, thus increasing the average acquisition costs of refiners by
about $.014 per gallon. As of mid-September, however, it appears likely
that the import duty will be removed.
Another price increase for OPEC oil looms on the horizon. Both
the world oil market and the words of OPEC representatives have softened
since the June 30 economic report of the Congressional Budget Office.
The forecasts presented in Chapter III of this report assume an OPEC
increase of $1.50 per barrel on October I. This OPEC increase implies
an increase of $.021 per gallon in the price of gasoline if controls
remain in force. While many OPEC observers believe that $1.50 per barrel is the most likely posted increase, the OPEC nations have surprised
the rest of the world before and may do so again. If there is an OPEC
increase of $1.50, if the tariff is removed, and if oil price controls
remain in force, CB0 estimates moderate additional inflation in oil
prices between now and early 1976 (by which time the full effect of the
OPEC increase will have been felt), and comparatively little inflation
from this source thereafter.
Immediate decontrol of old oil prices would change this picture
dramatically. Immediate decontrol, if not offset by other policies,
would add nearly 2 percent to the general price level and could retard
or even abort recovery (as discussed in Chapter V ) .
Another commodity that may show a significant price rise over the
next year is natural gas. Currently the Federal Power Commission (FPC)
has set a ceiling on the price at which natural gas producers sell gas
to interstate pipelines. The ceiling on natural gas prices appears to
have caused a decline in reserves and has led recently to unavailability of supplies for some high-priority users of natural gas.
One solution which has been proposed is the deregulation of natural gas prices. In the long run deregulation would have a sizable

14
effect on the price consumers pay for natural gas; but over a period
of a few years the price effect would be considerably lessened by the
fact that much gas is delivered under existing long-term contracts and
hence would not rise in price. Over the next two or three years, the
effects of deregulation of natural gas would be much less than those of
immediate decontrol of oil prices.
The beneficial effect of deregulation would be increased availability of natural gas. Federal Energy Administration officials estimate that comprehensive deregulation would reduce the expected shortages
by one-third this winter and more in future years. A recent FPC ruling
allowing affected industries to purchase supplies directly from producers at unregulated prices—in effect a partial deregulation of prices—
may succeed in reducing curtailments somewhat.
Wages. Labor costs do not seem to be a major factor in the current
acceleration of prices, as shown in Chart I. The best monthly indicator
available—the hourly earnings index for production workers in the private economy (seasonally adjusted but not including fringe benefits)—
has risen at an annual rate of 8.2 percent over the last eight months,
compared to a 10 percent annual rate in the last half of 1974. Over
the last two months the annual rate of increase has been 7.5 percent.
The Outlook for Prices
A number of factors in the recent price rise—Soviet grain purchases, for example, or the effect of last year's grain harvest on meat
prices—are one-time rather than continuing influences. For this reason,
CBO does not project a continuation of the double-digit inflation rates
of the last month or two during the remainder of 1975. Rather, CBO
expects a General Price Index (the GNP deflator) in the range of 189-191
(1958 = 100) in the fourth quarter, which implies an annual inflation
rate of 6 to 8 percent in the second half of 1975. This range is above
the actual rate during the early months of 1975, but well below 1973-74
rates.
Beyond 1975, the course of prices is much harder to foresee. The
most favorable outcome would include moderation of wage increases and
gains in productivity, leading to a steady reduction of price increases.
Because of the delayed effects of high grain prices and the probable
continued rise in fuel prices, that outcome at present does not seem
the most likely one. The worst outcome would be a new surge in food
prices, sharp rises in prices of uncontrolled domestic oil, and a substantial price boost by OPEC countries followed by a new round of
increases in wages and prices generally. This outcome can by no means
be ruled out at present. The next chapter of this report describes

15
a set of assumptions about food and fuel, as well as fiscal and monetary policies, leading to projections of prices through 1977.
It is widely recognized by now that inflationary shocks in food,
fuel, or other markets not only drive prices up but slow down economic
growth and recovery. This is because the higher prices reduce both
real income and real wealth of households, thereby causing households
to reduce purchases of goods and services. In the absence of vigorous
policies to counter this trend, substantial price shocks during the
next six months could, by late 1976 or 1977, weaken or even halt the
current economic recovery.
Production and Demand
The unemployment rate, after reaching a peak of more than 9
percent in the late spring, has begun to recede. Increases in
consumer buying and rapid declines in inventories give reason to
hope that recovery will be rapid in the next few months. The longer
run future is far less certain, however. Important economic sectors
such as housing and capital goods do not yet show evidence of sustained
growth, and renewed price increases could slow or even abort the
recovery.
Indicators of Recovery
For some months leading indicators of general business activity
have signaled that a recovery is under way. Leading indicators have
been combined by the Department of Commerce into a composite index
(recently revised), which turned up in March and has risen significantly each month since. Some of these indicators are the average
number of hours worked per week in manufacturing; the layoff rate in
manufacturing; manufacturers1 new orders for durable goods, in constant
dollars; and building permits issued for residential units.
Labor Market Indicators
Movements in indicators of labor demand are of particular
interest because they provide an advance look at likely trends in the
key variables of employment and unemployment, which sometimes lag
behind other major business cycle variables. The performance of two
such indicators, average weekly hours and the index of help-wanted
advertising (compiled by the National Industrial Conference Board),
confirms that an upturn is in progress. Both variables are rebounding from their early spring levels, although both still are very low by

58-216 O - 75 - 4

16
historical standards (as shown in Chart 2 ) . In past recessions, the
workweek has been among the first indicators to show any upward movement presaging recovery.
Two additional leading indicators, for which a decline is a sign
of improvement, are initial state unemployment insurance claims and
layoffs per 100 workers in manufacturing. These indicators have also
been among the first to signal recovery from past recessions. Both
variables, as Chart 3 shows, have improved since their extraordinarily
high peaks at the beginning of this year.
As for unemployment itself, the August, 1975, statistics show
that 7.8 million Americans were officially classified as unemployed
during the month, resulting in an unemployment rate of 8.4 percent
(seasonally adjusted). After rising sharply to 9.2 percent in May,
the rate had declined to 8.6 percent in June and 8.4 percent in July.
Although the overall rate did not change from July to August, there
was a decline for adult men (7.0 to 6.6) and a rise for teenagers
(19.1 to 21.I). The rate for a I I whites declined (7.9 to 7.6) while
that for blacks and other races rose (13.0 to 14.0).
The unemployment rate alone gives an incomplete picture of joblessness. During the second quarter of the year, according to the
Bureau of Labor Statistics, an additional 850,000 persons wanted jobs
but were no longer searching because they were discouraged by the
slack labor market. The number of these discouraged workers almost
doubled from the same period in the preceding year. In addition,
3.1 million persons were working only part time in August because
they were unable to find full-time work, down slightly from 3.2
million in July but up substantially from 2.6 mi I I ion in August, 1974.
The average duration of unemployment had also increased substantially, from 9.9 weeks in August, 1974 to 15.7 weeks a year later.
During August, 18.5 percent of all unemployed persons had been unemployed for twenty-seven weeks or longer, compared to only 7.8 percent
at the same time last year.
In summary, while there are numerous signs that a labor market
upturn is under way, the upturn is from an extremely low level so
that the unemployment problem remains severe with nothing resembling
full recovery in sight.

CHART 2—INDICATORS OF DEMAND FOR LABOR

Hours Worked Per Week, Total
Private Nonaqricultural
(seasonally adjusted)

38.0
37.5
37.0

V\ /

36.5
36.0

:
1968

1969

1970

1971

1972

1973

1974

1975

(continued)

CHART 2 (continued)--INDICATORS OF DEMAND FOR LABOR

Help-Wanted Advertising
(seasonally adjusted, 1967 = 100)

140
120

100

1958

Source:

1969

1970

1971

1972

1973

1974

U.S. Bureau of Labor Statistics; The Conference Board.

1
1975

CHART 3—LEADING INDICATORS OF UNEMPLOYMENT

Initial Claims for Unemployment Insurance
(average weekly claims in thousands, seasonally adjusted)

600
500

400
300

—**

200

1968

1969

1970

1971

1972

1973

1974

1975

(continued)

CHART 3 (continued)—LEADING INDICATORS OF UNEMPLOYMENT

Manufacturing Layoff Rate
(per hundred employees, seasonally adjusted)

k
\

An -A
1968

Source:

1969

1970

1971

1972

1973

1974

1975

U.S. Department of Labor; U.S. Department of Commerce, Bureau
of Economic Analysis.

21
Output, Final Sales, and Inventories
Basic to an understanding of the current economic outlook is a
separation of total output (GNP) into final sales to consumers, businesses, and government on the one hand and inventory change on the
other. Interplay between final sales and inventory change accounts
for a large share of month-to-month and year-to-year fluctuations in
output and employment. When final sales drop, inventory levels appear
excessive to businesses which, after a brief lag, usually reduce inventories. When final sales pick up, inventory levels soon begin to
appear insufficient, and after a lag, are usually increased. Inventory-sales interaction reemerged as a major factor in the economy in
1974-75, after playing only a minor role in the late 1960s and early
1970s.
In the most recent quarter, final sales (as measured by constantdollar GNP excluding inventory investment) increased significantly,
after little change in the first quarter of 1975 and a precipitous
decline in the fourth quarter of last year. These movements are compared in the left panel of Chart 4 to developments before and during
the 1957-58 recession—until recently, the sharpest output decline
since the end of World War II.
While final sales rose in the second quarter, inventories fell
rapidly, as the right panel of Chart 4 shows. During the sales declines of late 1974, businesses had simply been unable to cut output
as fast as final demand dropped, so unwanted stocks piled up at factories and retail establishments. In the first and second quarters of
1975 businesses succeeded in massively reducing these excess inventories. By the end of the second quarter, the inventory reduction and
the increase in final sales had brought the overall ratio of inventory
to final sales down considerably, though its level was still quite
high by historical standards.
The combination of rising final sales and sharp inventory liquidation in the second quarter is the kind of pattern likely to lead
to a significant rise in output during the next six months. Inventory
reduction seems most unlikely to continue at the huge second-quarter
rate, because much of the unwanted inventories has by now been sold
and final sales are now rising. A continued increase in final sales,
coupled with a moderate rate of inventory liquidation, would cause
a sharp increase in total GNP during the remainder of 1975. For
example, if the second quarter's 4.3 percent rate of increase in
real final demand continued through 1975 and if inventories were
depleted at a rate of minus $4.4 billion (1958 dollars) rather than
the minus $17.1 billion of the second quarter, real GNP would increase at an annual rate of 8 percent during the third and fourth
quarters of this year, while the inventory-final sales ratio still

22
CHART 4

FINAL SALES AND INVENTORIES IN TWO RECESSIONS
(ANNUAL RATE)

Final Sales
1973-1975

1958 Dollars,
Billions

Change in Business
Inventories
1973-1975

1958 Dollars,
Billions

840

830

820

810

800
1973

1974

1975

790
I

1973

1974

I
I
1975

Final Sales
1956-1958

1958 Dollars,
Billions

Change in Business
Inventories
1956-1958

1958 Dollars,
Billions

460

455 —

450 —

445 —

-5

-10

1956

Source:

1957

I
1956

I
I
1957

I I
1958

1958

U.S. Department of Commerce, Bureau of Economic Analysis.

23
would be reduced. Moreover, if this rate of growth were concentrated
mainly in one quarter, that quarter could show a double-digit rate
of growth in output. Such a rapid rate of growth could lower the
unemployment rate significantly; in fact, the average July-August
unemployment rate shown in Chart 5 suggests that this may already be
happening.
It is important to recognize, however, that a rapid rate of increase in output, stemming from an end to massive inventory liquidation, is not a symptom of underlying strength in the economy, but
rather a sign of the depth of the recession. The stimulus to output
coming from a rapid return to normal rates of inventory investment
usually lasts no more than a year. If recovery is to continue, the
stimulus from inventories must be replaced with expansion in final
demand. Judgment about the rate of expansion in 1976 and 1977 must
rest not on the inventory-sales situation but on an analysis of trends
in final demand.
Final Demand:

Consumer Spending

In the first half of 1975, the principal source of strength in
final demand was the consumer sector. Personal consumption expenditures, after a sharp decline in the last quarter of 1974, increased
somewhat in the first quarter of 1975, partly in response to the
price rebates on new autos offered to clear out overstock. In the
second quarter, incomes were bolstered by one-time payments from the
federal government—including rebates on 1974 income taxes and special
Social Security payments—and by a reduction in withholding rates.
Apparently much of this cash flow was not spent immediately; the
personal savings rate rose to the highest level since early 1946.
But enough was spent so that personal consumption expenditures rose
significantly, at a 6.3 percent annual rate in real terms.
In July and August, sales of domestic autos continued to rise.
Retail sales of other goods rose sharply in July, but fell back
somewhat in August. Recent trends in domestic auto sales are compared
in Chart 6 with 1956-58 trends. Data on consumer credit for June and
July suggest some increase in consumer willingness to incur new debt;
other measures of consumer confidence, while still low, have improved
from the nadirs registered last year.
While the savings accumulated during the second quarter may help
consumer spending in the near future, the situation of consumers still
is not encouraging. Second quarter increases in real disposable income
are largely attributable to the tax reductions and Social Security
payments, not to income generated in the private economy. With the
end of these special payments, personal income fell in July. Wage

24
CHART 5

UNEMPLOYMENT IN TWO RECESSIONS

Unemployment Rate
1973-1975

I
1973

I
I
1974

I I
1975*

*Third quarter 1975 partly estimated.

Unemployment Rate
1956-1958

Source:

I
I
1956

I I
1957

1958

U.S. Department of Labor, Bureau of Labor
Statistics.

25
and salary payments have risen in recent months, including July, but
have failed to keep up with the rise in consumer prices, including
those of food and energy. If renewed inflation, rising interest rates,
and falling stock prices continue, consumer spending will be discouraged.
Even the recent improvement in auto sales may prove to be temporary, as
was the case last summer when an upturn in sales turned out to be an
effort by consumers to beat higher prices on the 1975 models, rather
than the beginning of a recovery.
Final Demand:

Housing and Capital Spending

Residential construction activity finally started to improve in
the second quarter. The increase in housing starts, to a level 7.2
percent above the depressed first quarter, was both small and late compared with some previous recessions, though as Chart 6 shows it was
similar to the trend of early 1958. In July the rise continued and
included both single-family and multifamily housing. This increase in
starts is likely to be reflected in an increase in real residential
construction expenditures in the rest of the year.
Beyond that point the outlook is clouded. The recent upturn in
starts was aided through June by substantial flows of funds into thrift
institutions. These flows, however, slowed in July. Recent increases
in interest rates are reportedly causing funds to start to flow away
from the thrift institutions that supply much of the finance for the
housing market, toward direct investment in short-term financial paper.
The business capital goods sector typically does not add significantly fo final demand in the early stages of economic expansion. The
present recovery conforms to this pattern: although businesses anticipate a slight rise in the second half of this year in capital spending in current dollars, Chart 7 shows that price increases for capital
goods will translate the rise in current dollars into a leveling-off
in terms of actual new machines and plants.
There was a surge in contracts and orders for capital goods in
April, following the enactment of the new investment tax credit. Much
of this surge was apparently for electric utility plants with long lead
times, and may not be reflected in spending this year. Since April,
contracts and orders have been declining.
The Commerce Department survey of capital spending plans for 1975
indicates that many industries are planning reductions even in currentdollar terms. High fuel prices have led to cutbacks in investment plans
by auto manufacturers, airlines, truckers, and the many industries that
supply the auto industry. On the other hand, mining, pipelines, and
petroleum as well as other materials industries—which were characterized by shortages and high capacity utilization during the 1973 b o o m —

26
CHART 6

HOUSING STARTS AND AUTO SALES IN TWO RECESSIONS
(SEASONALLY ADJUSTED ANNUAL RATE)

Sales of Domestic Autos
1973-1975

Million
Units

1973

Million
Units

1974

1975*

1973

1974

1975*

*Third quarter data partly estimated.

*Third quarter partly estimated.

Sales of Domestic Autos
1956-1958

Million
Units

New Privately Owned Housing
Units Started
1973-1975

New Privately Owned Housing
Units Started
1956-1958

Million
Units
1.8

1.6

1.4

1.2

1.0

1956

I
I
1957

I
I
1958

0.8

I I
1956

Note:

Only annual averages are available for
1956-57; they are plotted at mid-year.

Source:

U.S. Department of Commerce.

I
I
1957

I
1958

27
CHART 7

BUSINESS EXPENDITURES FOR PLANT AND EQUIPMENT IN TWO RECESSIONS
(SEASONALLY ADJUSTED ANNUAL RATE)

1958 Dollars,
Billions

1973-1975

—

1973

1974

1975*

*Last two quarters of 1975 based on Department
of Commerce survey of expected spending. Deflators for last two quarters of 1975 projected by CBO.
1958 Dollars,
Billions

1956-1958

38 —A

1956

Source:

58-216 O - 75 - 5

1957

1958

U.S. Department of Commerce, Bureau of Economic
Ana l y s i s .

28
are expecting large increases in capital spending. This latter group
includes the steel and paper industries. Capacity shortages like those
of 1973 do not seem at all likely to develop in the next few years.
If consumer spending holds up next year, the outlook for an increase in investment spending will be better. Capacity utilization,
now very low, will increase when inventory liquidation ends, as well
as in response to increases in real final demand. A sharp decline in
corporate profits reversed itself in the second quarter, and profit
increases may be expected to supply funds for investment.
Final Demand:

Government Spending

The federal government sector also contributed to the increase in
final demand in the first half of this year. However, the spending
targets of the 1976 First Concurrent Resolution on the Budget, when
they are expressed in constant dollars, imply some slowdown for this
aggregate over the rest of the year.
State and local government spending, which showed no increase in
real terms during 1974, contributed to the rise in real final sales in
early 1975; this increase reflected federally funded public service
employment. Any further increases in such employment depend on future
federal legislation. An increased volume of construction spending is
expected later this year, despite the failure of municipal bond interest
rates to dec Iine.
While recovery in the economy will bolster tax receipts and facilitate further spending increases, renewed rapid inflation would cut into
the real purchasing power of both state and local governments and the
federal government, just as it does with private households.
Final Demand:

Net Exports

In real terms, net exports of goods and s e r v i c e s — e x p o r t s minus
imports—rose at an annual rate of $2.5 billion (1958 dollars) in the
first quarter and an additional $1.8 billion in the second. Factors in
the improved trade balance have been strong exports of machinery and
transportation equipment and a recess ion-induced decline in imports,
including petroleum products. July statistics recorded a sharp rebound
in petroleum imports from a very low June level, as well as an increase
in food exports. Net exports of merchandise overall were below the
second-quarter level. Whether exports will recede further or begin
to increase depends on the depth of the recession abroad, the extent to
which OPEC nations spend their dollar balances, and the magnitude of
foreign grain purchases from the United States.

29
The Outlook for Production and Unemployment
The charts accompanying this chapter suggest
between the current period and the recovery after
Although the recent decline has been steeper than
the interaction between inventories and sales and
categories of final demand have been similar.

some similarities
the 1958 recession.
the 1957-58 decline,
movements in some

It is worth recalling, therefore, that what looked like a vigorous
recovery in 1958 never went far enough to restore unemployment and
capacity utilization to normal levels. Initially, real GNP rose from
its recession low at a 10 percent annual rate for two quarters. But by
I960 the upswing had stalled and a new recession was under way. The
unemployment rate never reached the 1956 level during the 1958-60 expansion; in fact it did not reach that level until 1965. Both fiscal
policy, as measured by the full employment budget surplus, and monetary
policy, whether measured by the rate of change in the money supply or
by interest rates, turned restrictive by late 1959 and contributed to
the I960 downturn.
CBO projections suggest a sharp recovery for the remainder of
1975, much like the early stage of the 1958-60 recovery. In real terms,
GNP is expected to grow at an annual rate of nearly 8 percent from the
second to the fourth quarter, and the unemployment rate is expected to
remain in the 8.1 to 8.6 percent range, compared to 8.9 percent in the
second quarter. The vigor of the upturn reflects the shift from
sharp inventory reduction to inventory stability and the rise in consumer spending stemming in part from the one-time tax rebates of May
and June.
Rebuilding inventories, of course, will not sustain the recovery
for long. Continued increases in production and reduction of unemployment depend on continued growth in final demand for consumer goods,
housing, capital goods, and exports. At present the strength of sustained increases in final demand is very much in doubt.
The CBO projections detailed later in this report point to a
slowdown in the recovery starting in mid-1976, although the recovery
still will be more sustained than that of 1958-60. Nevertheless, as
indicated above, energy and food price developments and a restrictive
monetary policy could abort the current recovery after a relatively
brief upswing. And it is in any case true now, as it was in 1958,
that even two years of vigorous recovery still will leave a sizable
gap between actual and potential output. It is important not to confuse rapid increases from current depressed conditions, which are
likely to take place over the next six months, with high I eve Is of
resource utiIization.

CHAPTER I I I
THE OUTLOOK
Current economic news suggests that the upturn in production will
be rapid over the next few months, but that a renewal of inflation—
initially stemming from food and fuel price increases—will accompany
the upturn. CBO ! s projections for the last quarter of 1975 reflect
these trends, GNP in constant dollars is expected to grow at approximately an 8 percent annual rate from the second through the fourth
quarter of 1975. Unemployment is expected to fall within the 8.1 to
8.6 percent range by the last quarter of this year, compared to the
second quarter's 8.9 percent. Meanwhile, the general level of prices
is expected to rise at a 6 to 8 percent annual rate, compared to the
second quarter's 5 percent.
Current data provide only partial guidance as to the main forces
likely to be shaping the economy beyond the next few months. It is
necessary to supplement these data with assumptions about future fiscal
and monetary policies and other key influences. This chapter explains
CBO's assumptions about these influences and projects major economic
indicators through the end of 1977. As with all such projections, the
margin of possible error is very wide, not only because some of the
assumptions may turn out to be wrong, but also because the translation
of assumptions into specific forecasts of unemployment, prices, or GNP
involves many judgments and uncertainties.
Key Assumptions
Current trends suggest two ways in which the economy is likely to
change in 1976 and 1977. First, the rapid rates of growth in output
projected for the next few months are likely to slow sometime in 1976.
Second, inflation is likely to remain above the 5 to 6 percent annual
rate of this spring.
A slowdown in the growth of output is forecast because two major
causes of current growth are temporary. One is the tax rebates maTTed
out in May and June. These have helped the current strength in retail
sales, but they will have much less impact on sales a year from now.
The other is the shift from sharp inventory reduction to mild reduction
or stability, which should stimulate new orders and production in the
months ahead, but will not repeat itself later in the recovery.

(.31)

32
Persistence of inflation rates above 5 to 6 percent is forecast
because the food and fuel increases revealed in recent price reports
will take some time to work their way from wholesale to retail levels
and through the entire wage-price structure. Increases in the wholesale price of grains exert much of their influence on retail food
prices by increasing the cost of livestock. Generally, this does not
raise meat prices until nine months or more later. Increases in oil
prices may show up fairly promptly at the gasoline pump, but generally
less promptly in prices of fuel-using goods and services, such as
apartment or office rents. And price increases of all kinds may set
in motion a round of wage increases higher than they would otherwise
be, which then would have a further impact on prices.
A steady course is assumed for fiscal policy: adherence to the
first concurrent resolution (including extension of the tax cuts of
1975) through fiscal year 1976 and extrapolation of recent trends in
outlays beyond then. For some items in the budget, such as income tax
receipts or outlays for extended unemployment compensation benefits,
unexpected economic developments clearly can cause dollar amounts to
exceed or fall short of any set of targets. CBO's projections have
allowed these "uncontrollable" items to respond to such developments
rather than adhering strictly to the dollar targets in the first concurrent resolution.
The monetary policy projections are based on the assumption that
the rate of monetary growth will be reduced gradually below recent
levels. Specifically, the rate of growth of demand deposits and currency is assumed to be just above a 7.5 percent annual rate from the
second to the fourth quarters of this year (as compared to a rate of
9.3 percent from the first to the second quarter), slightly more than
7 percent from the fourth quarter of 1975 to the fourth quarter of
1976, and moderately below 7 percent thereafter. Thus, rates of monetary growth in 1976-77 are assumed to fall within the 5.0 to 7.5 percent range announced by the chairman of the Board of Governors of the
Federal Reserve System. These declining rates of growth contribute to
the projected slowdown in growth but in the long run lessen somewhat
the projected rate of inflation.
Among the major uncertainties about the energy outlook are the
future of decontrol of old oil prices and OPEC price policies. CBO
projections assume that domestic oil prices remain controlled, the
tariff on imported oil is removed, and OPEC increases the price of imported oil by $1.50 a barrel as of October, 1975.
Finally, the projections assume that farm prices will rise at 9
percent per year. While this is less rapid than the farm price spurt
of the last two months, it greatly exceeds the average rate

33
last year and a half. Farm prices, in conmast to oil prices, are
assumed to be a major source of inflation ahead.
Projections, 1975-77
Projections based on these assumptions for the final quarters
of 1975, 1976, and 1977 are shown in Table 4. Statistical models of
the economy and less formal judgments about key economic relationships
both were used in making the projections.
The projections indicate a fairly rapid recovery during the remainder of the current year and the early part of 1976, followed by
slower growth during the rest of 1976 and 1977. The unemployment rate
is projected to continue dropping in 1976, but to fall much less rapidly
in 1977• Specifically, the projections of the unemployment rate lie
between 6.6 and 7.5 percent at the end of 1977, as compared with a
1946-74 average of 4.7 percent.
The projections indicate that price increases will recede from
their current high levels, but remain well above what used to be considered normal. Specifically, by the end of 1977 the projections in^
dicate a rate of inflation of the general price level (the GNP deflator)
of 5.5 to 7.0 percent, as compared with a 1946-74 average of 3.7
percent.
With respect to 1976, the projected inflation rates are slightly
higher than ones presented by the budget committees at the time of the
first concurrent resolution; with respect to unemployment, the two sets
of projections are about the same. The CBO report on the economy
issued on June 30, 1975, projected higher unemployment rates, but the
recent drop in unemployment and the favorable movements in leading indicators of labor market growth have led to some scaling down of those
projections. The assumption of no decontrol of oil prices has also
lowered the projected rate of unemployment.
The inflation rates in the forecast are heavily influenced by the
assumed OPEC price increase and the acceleration of food prices above
their 1974-75 rates of increase.
The growth in aggregate demand has
relatively little to do with the rates of inflation projected. Not
until the end of 1977 does even the optimistic end of the projection
range represent a level of utilization in which aggregate demand
changes do begin to approach their normal effect on prices.
The federal deficit is not projected in Table 4 because of an exceptional ly large range of estimates arising from different models for
estimating federal revenues. It is worth noting, however, that for

TABLE 4—ECONOMIC PROJECTIONS, 1975-77

Actua1
1975:11

Projected
Range:
1975:IV

Projected
Range:
1976:IV

Projected
Range:
1977: IV

Percent Change
1975:IV to
1976:IV

Percent Change
1976:IV to
1977:IV

1440

1535-1560

1735-1765

1895-1935

+ 1 1.5-14.5

+8.0-12.0

GNP (1958 dollars,
annual rate)

783

810-818

854-867

880-900

+5.0-7.0

+2.0-5.0

General Inflation
Index (GNP deflator,
1958 = 100)

184

189-191

200-205

210-220

+6.0-7.5

+5.5-7.0

Consumer Price Index
(1967 = 100)

160

165-167

175-181

186-195

+6.5-8.0

+6.0-8.0

Unemployment Rate
(percent)

8.9

8.1-8.6

6.9-7.6

6.6-7.5

—

GNP (current dollars
annual rate)

Note:

Dollar amounts are expressed in billions.

35
fiscal year 1976 the range of estimates includes the $68.8 billion
deficit voted in the first concurrent resolution. While different
models are far from agreement about future trends in the deficit, they
provide no basis for rejecting $68.8 billion for 1976.
The growth in constant-dollar GNP projected through 1977 is compared in Chart 8 with a projection of potential GNP, or the GNP the
economy would produce at a 4 percent unemployment rate. Actual as a
percent of potential GNP increases from its most recent level of 85
percent to 88 to 90 percent at the end of 1977. Uncertain as this
estimate is, it nevertheless serves to indicate that in spite of a recovery which initially may look healthy by historical standards, there
is a strong likelihood that the economy will continue to function well
below capacity for some years to come.

36
CHART 8

ACTUAL AND POTENTIAL GNP, 1972-77

1958 Dollars,
Billions
1000

Potential GIMP

900

CBO
Projections
800

700
I

I I
1972

Source:

I I
1973

I I
1974

J
1975

I
1976

1977

(I) 1973-75:2—Department of Commerce (GNP), Council of Economic
Advisers (potential GNP); (2) 1975:3-1977—CBO. Potential GNP
has been extrapolated at 3.5 percent per year, or less than the
4 percent rate used by the Council of Economic Advisers, to take
account of low levels of capital investment in 1975 (actual) and
1976 (projected).

CHAPTER IV
ALTERNATIVE FISCAL AND MONETARY POLICIES
With both unemployment and inflation likely to remain above longrange goals for some time, economic policy-makers face a continuing
dilemma. Fiscal and monetary policies, the traditional instruments for
controlling economic fluctuations, can alleviate unemployment only at
the expense of more inflation, and vice versa. Expansionary p o l i c i e s —
more government spending, tax cuts, or greater monetary growth—bring
down unemployment at lea^t for a time, but eventually take their toll
in the form of a higher rate of inflation than would otherwise occur.
Restrictive policies eventually reduce inflation, but at the cost of a
higher rate of unemployment.
To be sure, an expansionary p o l i c y — f o r example, a $5 billion
increase in federal spending—does not always have the same effects on
unemployment and inflation. There are good reasons to believe that at
present the unemployment effects would be unusually large and the inflation effects unusually small, so that an expansionary policy at present
would reduce unemployment more than usual and add to inflation less than
usual. One reason is that wages are less sensitive to the unemployment
rate when it exceeds 8 percent than they would be when it is at 4 or 5
percent. In addition, capacity bottlenecks that reduce supplies and
drive up prices are much less likely to occur when industrial output is
at 75 percent of capacity than when it is at 90 or 95 percent.
In all likelihood a restrictive policy would also have different
effects at the present time than would normally be anticipated. It
would probably reduce inflation by less than usual and add to unemployment more than usual. Thus the tradeoffs between the costs and benefits
of economic policies shift as the economy changes; but they never disappear entirely.
In the long run the solution to this dilemma may lie in redesigning
or adding to the available policy tools. A policy tool that reduced
inflation without increasing unemployment, or reduced unemployment without escalating inflation, would be a welcome contribution to economic
stability, at least if it did not have other unwanted side effects.
One tool which the United States has used intermittently is price
and wage controls, which are intended to keep prices down without increasing unemployment. However, price and wage controls are extremely

(37)

38
difficult to administer even-handed Iy and sometimes reduce supplies or
otherwise interfere with the efficient working of markets.
Special measures to stimulate employment in recession—such as
public service employment—can be designed to create more jobs per billion dollars than standard fiscal policy instruments such as acrossthe board tax cuts.' If such measures are focused on creating jobs for
low-skilled workers at low wages, they have relatively little adverse
effect on inflation.
The analysis in the present report is restricted to the traditional
policy tools of government spending, tax changes, and monetary expansion. The first section below summarizes the current state of fiscal
and monetary policy. The second section analyzes some policy alternatives grouped into two strategies: (I) an expansionary strategy consisting of a spending increase, a tax cut, and a greater rate of monetary growth; and (2) a restrictive or anti-inflation strategy consisting
of a spending cut, a tax increase, and a lower rate of monetary growth.
In each case the economic effects of the components of the package are
estimated, as are the effects of the entire strategy.
Current Fiscal and Monetary Policy
Since the tax rebates of this spring, fiscal policy has adhered to
a steady course, while monetary policy has shown signs of tightening.
There will be a large deficit in the current fiscal year, but one which
is entirely attributable to the depressed state of the economy. The
Federal Reserve Bank of St. Louis has estimated that the budget would be
close to balance on a full-employment basis. The Federal Reserve System
has been pursuing monetary growth targets that are quite high compared
to historical averages; but historical averages are not extremely useful in the current era of continuing inflation and inflationary expectations. Recent increases in short-term interest rates and decreases
in monetary growth are both signs of a move toward tightness.
F i sea I PoIi cy
On the fiscal side, as Table 5 shows, spending bills completed by
the Congress or under way in the House of Representatives (where spending
bills originate), amount to a total of $291.3 billion or $75.7 billion
less than the outlay target in the 1976 First Concurrent Resolution on
the Budget.
'•
Temporary Measures to Stimulate Employment: An Evaluation of Some
Alternatives, Congressional Budget Office, U.S.Congress, September 2, 1975.

TABLE 5--FEDERAL OUTLAYS FOR FISCAL 1976
(bilI ions of dollars)

First Concurrent
Resolution Target

Comp1eted
Action and
House Action
Under Way

90.7

24.8

65.9

71.0

International Affairs

4.9

3.4

1.5

1.6

General Science, Space and
Technology

4.6

4.5

0.1

—

1 1.6

10.7

0.9

0.4

1.8

2.2

(0.4)

—

17.5

16.4

1. 1

0. 1

2.35

0.2

Functional Category

National Defense

Natural Resources, Environment
and Energy
Agriculture
Commerce and Transportation

Di fference
(1 minus 2)

President's Spending
Requests Not Yet
Reported in House

Community and Regional
Development

8.65

6.3

Education, Manpower and
Social Services

19.85

19.0

0.9

0.3

Health

30.7

32.4

(1.7)

0.4

125.3

122.5

2.8

3.3

Income Security

(continued)

TABLE 5 (continued)--FEDERAL OUTLAYS FOR FISCAL 1976
(billions of dollars)

Fi rst Concurrent
Resolution Target

Comp1eted
Action and
House Action
Under Way

17.5

16.7

0.8

1.7

Law Enforcement and Justice

3.4

3.2

0.2

0.1

General Government

3.3

2.9

0.4

0.3

Revenue Sharing and General
Purpose Fiscal Assistance

7.2

7.0

0.2

0.3

35.0

—

1.2

0.3

0.9

(16.2)

367.0

291.3

Functional Category

Veterans' Benefits and
Services

1nterest
Allowances
Undistributed Offsetting
Receipts
TOTAL

Source:

President's Spending
Difference
Requests Not Yet
(1 minus 2)
Reported in House

0
75.7

1.3
—
80.9

Congressional Budget Office, 1976 Congressional Budget Scorekeep ing Report No. 2 (as of
September 2, 1975).
(continued)

TABLE 5 (continued)—FEDERAL OUTLAYS FOR FISCAL 1976
(bill ions of do Ilars)

Notes:
1. Columns may not total due to rounding.
2. Column one contains the figures for Congressional outlay targets from the (first concurrent
resolution on the budget (H. Con. Res. 218).
3. The figures in column two are the sum of completed legislation (passed Congress) plus action
under way in the House of Representatives. The House rather than the Senate was used because spending legislation is usually first acted on in the House. Included in the figures in this column are
outlays enacted in prior years, outlays enacted in this session, outlays passed by Congress but not
signed, and outlays that have been reported in or have passed the House. In all cases outlays are
estimates of the impacts of Congressional action.
4. Column three is the difference between column one and column two and represents the estimated outlays (contained in the concurrent resolution) that have not yet been reported into the
House.
5.

Column four represents the President's spending requests not yet reported in the House.

42
However, Presidential requests of $80.9 billion remain to be acted
upon by the House. If all these outstanding Presidential requests were
honored by both the House and the Senate, then total outlays would
exceed the first concurrent resolution by about $5 billion. One major
uncertainty is in the area of national defense, where Presidential
requests are significantly above the additional amount Congress can
appropriate and stay within the target. Other influences on the final
course of spending are unanticipated changes in "uncontrollable" items
such as unemployment compensation, Presidential vetoes and override
attempts, and new spending legislation.
The targets of the first concurrent resolution include a federal
deficit of $68.8 billion. The large size of the deficit can be attributed almost entirely to the effects of the recession on tax receipts,
outlays for unemployment insurance, and other forms of income assistance.
Of course the fact that the deficit would disappear if the country were
enjoying full employment does not eliminate the Treasury's current need
to borrow in order to finance it. However, this fact does suggest that
if the economy gradually approaches higher levels of employment over the
next few years, strong forces will be in motion reducing the size of the
deficit.
Monetary Pol icy
Since early 1974 the Federal Open Market Committee of the Federal
Reserve System has set short-run targets for an interest rate (federal
funds rate—the short-term interest rate banks charge each other to
borrow money) and for growth rates of two stocks of financial assets:
the narrowly defined money supply including demand deposits and currency
(M|), and a broader definition of money including bank saving deposits
(M2). Targets in all three cases are expressed in the form of ranges
within which actual amounts are intended to fall. Which of these three
represents monetary policy is not easy to determine; the Federal Reserve
is rarely able to hit all three targets simultaneously and in fact frequently misses all three of them. In June, for example, as Table 6
shows, the federal funds rate was slightly above the intended range while
both monetary rates of growth were far above the target levels. What,
then, was monetary policy in June?
The answer is probably that monetary policy strives for a compromise
among the various goals, and in addition allows for special unanticipated
developments as each month progresses. In June, for example, monetary
growth rates were heavily and artifically swollen by the unexpectedly
large impact of $50 payments to Social Security recipients and certain
other beneficiaries, a one-time fiscal development that also lowered
growth rates artificially in July. Special developments of this sort are
permitted to show up as deviations from the target ranges. Revisions and

TABLE 6—FEDERAL OPEN MARKET COMMITTEE MONEY AND
INTEREST RATE TARGETS IN 1975

Rate of Growth from Preceding Month
(percent per year)
Month

M2
Actua1

January
February
March
Apri 1
May
June
July
August

Source:

-8.9
5.7
11.6
4.3
1 1.4
19.3
2.1
4.3*

Target Range
5-7
3.5 - 6.5
5.5 - 7.5
5 - 7.5
6.5 - 9
7 - 9.5
6.5 - 9.5
3 - 5.5

Actaa1

Target Range

4.0
9.8
12.5
7.9
14.0
20.5
8.7
6.2*

7.5 - 10
7-10
6.5 - 8.5
8-10
9.5 - 11.75
9 - 11.5
9 - 12
8 - 10.5

Level of Federal
Funds Rate
(percent)
Actual
7.1
6.2
5.5
5.5
5.2
5.6
6.1
6.2

Target Range
7.5 - 9.0
6.5 - 7.25
5.25 - 6.25
4.75 - 5.75
4.75 - 5.75
4.5 - 5.5
5-6
5.5 - 6.75

Federal Reserve Bulletin, various issues.

*Preiiminary.
Notes:
1. M.—demand deposits and currency.
2. M2—M| plus bank time and savings deposits except for large negotiable certificates of deposits.

44
lags in the availability of money supply data also account for some of
the deviations from targets.
If a combination of interest rate targets and money growth targets
is used to describe current policy of the Federal Reserve System, then
tightening of monetary policy appears to be taking place. The target
range for the growth rate of the narrow money supply was raised gradual ly from February to June but in July and August the range was dropped.
The targets were also lowered in August for the broader money supply.
The federal funds rate targets had been lowered from January to June,
but were raised in July and August. The lowering of target rates of
monetary growth and the raising of interest rate targets are both signs
that monetary authorities are moving toward a tight policy.
In fact, short-term interest rates, and even long-term rates have
been rising since first-quarter lows. To be sure, a general rise in
interest rates during a recovery in economic activity, is not uncommon.
During the first year of recovery from all the recessions since World
War II, the average rise in the Treasury bill rate was roughly 33 percent
of its level at the bottom of the economic cycle. The current situation
is unusual because of the immediate and significant increases in shortterm rates while output is still far below its potential. There is growing concern that rapid and large increases in interest rates could
seriously affect the already weak housing sector, perhaps enough to undermine a vigorous recovery.
Pol icy Alernatives
Alternative policies analyzed in this report are divided into an
expansionary strategy and a restrictive strategy. Each strategy consists of a spending component, tax component, and a monetary component.
The expansionary strategy as a whole is estimated to lower the unemployment rate by I.I percentage points by the end of 1977, so that the
basic CBO projection of unemployment at 6.5 to 7.5 percent would be
lowered to 5.4 to 6.4 percent if the expansionary strategy were added.
The restrictive strategy as a whole is estimated to raise the unemployment rate by 0.9 percentage points by late 1977. The unemployment effects of these strategies would slowly decline in later years.
Since the inflation effects of these policies are slow to develop,
it is necessary to look far ahead to form a realistic judgment of the
inflationary damage of the expansionary strategy or the inflationary
improvement of the restrictive strategy. Looking only one or two
years ahead can give misleading signals about the inflation consequences
of economic policies. In order to reach a judgment (necessarily approximate) about long-run inflation effects, CBO has constructed a simple

45
model that can trace the inflation consequences of a change in unemployment, in farm prices, or in fuel prices.2
Based on this model, CBO estimates that the expansionary strategy
would raise the rate of inflation by 0.5 to 0.7 percent at the end of
five years; that is, if the rate of inflation in the absence of the
policy were 5 percent per year, then the rate with the policy would be
5.5 to 5.7 percent. In the case of the restrictive strategy, the annual
rate of price increases at the end of five years would be 0.3 to 0.4
percent lower. In both cases, inflation effects are negligible in the
first year and then build more significantly by the end of five years.
Beyond five years, inflation effects diminish gradually.
The Expansionary Strategy
The expansionary strategy consists of the following three
components:
(1) an increase in spending of $5 billion (annual rate) in the
first quarter of 1976 and $10 billion (annual rate) thereafter,
divided equally among defense purchases, nondefense purchases,
and grants-in-aid;
(2)

a cut in personal tax rates (above the extension of the 1975
cuts) starting in the first quarter of 1976 that loses approximately $15 billion in revenues (annual rate) during that
quarter with somewhat greater revenue loss as incomes grow;
and

(3) a rate of growth of the money supply sufficiently high to offset the effects on short-term interest rates of the fiscal
components and hence keep interest rates at levels projected
in the basic forecast.
The estimated effects of these policies are shown in Table 7. As
the final column in the table shows, the three components together b u U d
up to a substantial effect on GNP and unemployment by the end of 1977.
2.
The model consists of two equations fit to annual data, a pricechange equation and a wage-change equation. Price changes depend on
fuel price changes, farm price changes, and current and previous-year
wage changes. Wage changes depend on the unemployment rate and on current and past price changes. There are two versions of the model, each
with a different constraint on the sum of the price-change coefficients
in the wage equation. A description of the model will be available from
CBO on request.

TABLE 7--P0LICY ALTERNATIVES: ESTIMATED EFFECTS OF
EXPANSIONARY FISCAL AND MONETARY POLICIES

Combined Spending,
Tax, and Monetary
Components

Spending
Component

Tax
Component

Monetary
Component

Current-Do 1lar GNP
(bill ions):
1976:IV
1977:IV

+ 18
+24

+ 18
+28

+ 5
+ 13

+39
+63

Real GNP
(bill ions):
1976:IV
1977:IV

+ 8
+ 9

+ 9
+1 1

+ 2
+ 6

+ 19
+25

Unemployment Rate
(percentage points):
1976:IV
1977:1V

-.4
-.4

-.3
-.4

-.1
-.3

-.7
-I.I

EFFECT OF POLICY ON:

(continued)

TABLE 7 (continued)—POLICY ALTERNATIVES: ESTIMATED EFFECTS OF
EXPANSIONARY FISCAL AND MONETARY POLICIES

Spending
Component

Tax
Component

Monetary
Component

Combined Spending,
Tax, and Monetary
Components

Federal Deficit
(bill ions; national
income basis):
1976:IV
1977:IV

+ 5
+ 4

+ 12
+1 1

- 2
- 4

+ 15
+ 10

Inflation Rate
(annua1 rate of
change, General
Price Index):
1976
1977
1980

0
+.2
+ .2

-.1
+-. 1
+ .2

0
+ .1
+ .2

0
+ .4
+.5 to +.7

48
The monetary component contributes less than the other two components to the strategy for two reasons. First, the size of the monetary
component was determined by calculating the change in monetary policy
needed to offset the effects on short-term interest rates of the two
fiscal components; this "accommodating" change turned out to be only
about 0.5 percent per year in the rate of monetary growth. Second,
the contribution of the monetary component is small because monetary
policy operates with longer lags than fiscal policy. The effects of
the spending and tax components will have reached their peak by the
end of 1977 but the effects of the monetary component will still be
growing.
The unemployment effects of the spending increase are equal to or
larger than those of the tax cut, despite the fact that the expenditure
increase initially is only $10 biI I ion and the tax change initially is
$15 billion, and more by 1977. One reason is that dollar for dollar,
expenditure increases have a greater effect on economic activity than
do personal tax cuts. The other reason is that some expenditures result in direct federal employment; during an early recovery period such
an expenditure creates more jobs per dollar than do expenditures in the
private sector. In the private sector, employment is reduced by less
than total spending during a recession and increased by less than total
spending during early recovery; increased spending in early recovery
serves to restore normal profit margins and pay off debts, as well as
to hire additional workers. In the federal sector these special earlyrecovery effects are absent.
The effects of the two fiscal components on the federal deficit are
smaller than the initial size of the components. That is, a $10 billion
increase in spending results in an increase in the deficit of less than
$10 billion, and a $15 billion tax cut increases the deficit by less
than $15 billion. This is because the economic growth stimulated by
these fiscal moves brings in additional tax revenues and reduces outlays for income assistance programs; these offset some of the direct
effects of the deficit. The growth stimulated by monetary expansion
also brings in tax revenue, reduces income-assistance outlays and hence
reduces the deficit.
No "crowding out" of private investment is expected to occur under
these policies. The spending and tax components, separately or
together, do drive interest rates up and this rise has a dampening
effect on private investment; but the interest rate effect is more than
offset by the stimulus to investment from the higher sales which expansionary policies induce. Private investment (not shown in the table)
rises, not falls, in response to more government spending or lower taxes.

49
The Contractionary Strategy
The restrictive policy alternative consists of the following three
components:
(1) a cut in spending of $5 billion (annual rate) below the first
concurrent resolution in the first quarter of 1976 and $10
billion thereafter, divided equally between nondefense purchases and grants-in-aid;
(2) termination instead of extension of the temporary provisions
of the Tax Reduction Act of 1975; and
(3) a rate of monetary growth sufficiently low to offset the
interest rate effects of the fiscal components and hence keep
interest rates at levels projected in the basic projections.
The estimated effects of these policies are shown in Table 8. The
three components together are estimated to raise the unemployment rate
by 0.6 percentage points at the end of 1976 and 0.9 percentage points
at the end of 1977. The inflationary gain from the package is estimated as a 0.3 to 0.4 percent reduction in the annual rate of inflation
after five years. Many of the comments about the details of the expansionary results carry over to the restrictive results.
In summary:
»

The expansionary fiscal-monetary strategy would lower unemployment by I.I percentage points at the end of two
years and would raise the rate of inflation for some years
beyond that, reaching a peak inflation effect of about
0.5 to 0.7 percent.

•

The restrictive strategy would raise the unemployment rate
by 0.9 percentage points at the end of two years and would
lower the rate of inflation for several years, reaching a
maximum reduction of 0.3 to 0.4 percent.

•

The expansionary package would raise the federal deficit,
although higher tax revenues and lower income-support payments would offset much of the effect of the tax and
spending moves.

•

The restrictive strategy would lower the deficit, again by
much less than the direct effects of the spending and tax
moves.

TABLE 8—POLICY ALTERNATIVES: ESTIMATED EFFECTS
OF CONTRACTIONARY POLICIES

Tax
Component

Monetary
Component

-14
-23

- 9
-17

- 4
-II

-28
-49

Combined Spending,
Tax, and Monetary
Components

Spending
Component

- 4
- 7

- 2
- 5

-14
-20

+ .2
+ .3

+ .1
+ .2

+ .6
+ .9

EFFECT OF POLICY ON:
Current-Do 1lar GNP
(bi1 lions):
1976: IV
1977:IV

Unemp1oyment Rate
(percentage points):
1976:IV
1977:IV

Real GNP
(billions):
1976:IV
1977:IV

+ .3
+ .4

(continued)

TABLE 8 (continued)—POLICY ALTERNATIVES: ESTIMATED EFFECTS
OF CONTRACTIONARY POLICIES

Spending
Component

Tax
Component

Monetary
Component

Federal Deficit
(bill ions; nationa1
income basis):
1976:IV
1977: IV

- 6
- 4

- 9
-10

+ 2
+ 4

Inflation Rate
(annual rate of
change, General
Price Index):
1976
1977
1980

0
-.1
-.2

0
-.1
-.1

0
0
-.1

Combined Spending,
Tax, and Monetary
Components

-12
-10

0
-.2
-.3 to -.4

CHAPTER V
THE IMPACT OF DECONTROL OF OIL PRICES
A major uncertainty clouding economic forecasts at present is the
future course of energy prices, especially oil prices. Rapid increases
in the price of oil in the next few months could touch off another
round of inflation and drastically impede progress toward reducing
unemployment.
At least three new developments could change oil prices substantially in the short-run: (I) the controls limiting the price of old
domestic o i P to $5.25 a barrel have recently lapsed; if they are not
reimposed, the price of domestic crude oil will rise; (2) the OPEC
nations could raise the world price of oil from its present level;
(3) the special U.S. import fee of $2.00 per barrel on crude oil and
$.60 per barrel on refined products could be removed.
The CBO projections of the economy describee in Chapter II were
based on the following assumptions: that the import fees would be removed; that OPEC would raise the price of oil by a $1.50 per barrel in
October, and then hold the price at that level; and that domestic prices
of old oil would remain controlled. The President has stated that he
will voluntarily drop the tariff if controls end; if controls remain,
court action may void the duty in any case. Some OPEC increase in
October seems extremely likely. It may be somewhat greater or less
than $1.50, but a difference of $.50 in either direction would not make
a large difference in CB0 f s projections. Decontrol is another matter,
however. While gradual decontrol—say, over a period of thirty-nine
months as proposed by the President—would not have a major effect on
the projections, immediate decontrol would have a substantial impact
both on inflation and on the progress of economic recovery.
This chapter examines the impact of immediate decontrol and the
fiscal measures that would be required to offset this impact.

3.
Essentially, old oiI is that which is driI led from we I Is in
existence before September I, 1972.

(.53)

54
The Costs and Benefits of Decontrol
A report such as this, whose focus is on prospects for economic
recovery, cannot deal adequately with all the complex considerations
involved in striking a balance between the pros and cons of decontrol.
The objective of this chapter is more modest: to document and quantify
the rather substantial costs of immediate decontrol in terms of greater
inflation and higher unemployment—a burden that is particularly heavy
on an economy just beginning to emerge from a severe recession.
But it must be stressed that decontrol has benefits as we I I as
disadvantages. For one thing, ending controls would mean the dismantling of a cumbersome system of government regulations that may distort
decisions of drillers, refiners, and consumers alike. For another, the
higher price of oil would induce greater conservation. Given the role
of imported oil in the United States—that of filling the gap between
domestic production and domestic consumption—the entire impact of
reduction in consumption would be reflected in imports. CBO estimates
that U.S. reliance on imports would be reduced by nearly 700,000 barrels per day by the end of 1977. In addition, tertiary recovery from
old oil fields would be encouraged, while higher oil prices also would
accelerate the development of alternative energy sources.
Effects of Decontrol on the Recovery
CBO's analysis indicates that immediate decontrol of oil prices
would significantly retard the growth of output and employment while
simultaneously setting back the battle against inflation. If old oil
prices were to be decontrolled gradually, the shock to the nation's
economy would be less severe. The increase in the fuel bill would be
more likely to come when the economy was stronger, and thus in a better
position to cope with it.
Table 9 presents the estimated effects of immediate decontrol on
some principal economic variables in the fourth quarters of 1975, 1976,
and 1977. For the convenience of the reader, a single number is presented for each variable in each quarter. In reality, no one can
anticipate the economic effects of decontrol with this degree of accuracy. The estimates in the table were derived with the aid of the
three statistical models of the economy: those of Chase Econometrics,
Inc.; Data Resources, Inc.; and Wharton Econometric Forecasting
Associates.
According to CB0 f s estimates, decontrol would increase wholesale
prices by nearly I percent by the end of 1975 and nearly 4 percent by
the end of 1977. Consumer prices would not rise as much as wholesale
prices because oil is more important in the Wholesale Price Index than

55
TABLE 9—ESTIMATED EFFECTS OF
DECONTROL OF OIL PRICES

1975:IV

1976:IV

1977:IV

Wholesale Price Index
(percent)

+0.9?

+3.4?

+3.8?

Consumer Price Index
(percent)

+0.4?

+ 1.6?

+ 1.8?

General Inflation Index
(GNP deflator, percent)

+0.5?

+ 1.5?

+ 1.8?

Gross National Product in
constant dollars (billions
of 1958 dollars)

-$2.5

-$12.1

-$17.2

Unemployment Rate
(percentage points)

+0.1

+0.5

+0.6

Gross National Product in
current dollars (bi11 ions
of dollars)

+2.3

+ 1.9

-$3.2

Federal Budget Deficit
(bill ions of dollars,
National Income
accounts basis)

-$3.2

-$4.4

-$0.4

+$.031

+$.067

+$.061

+0.4?

+0.5?

EFFECT OF DECONTROL ON:

Retail Price of Refined
Petroleum Products
(cents per gal Ion)
Average Hourly Wage Rate
(percent)

(continued)

56
TABLE 9 (continued)—ESTIMATED EFFECTS OF
DECONTROL OF OIL PRICES

1975: IV 1976:IV

1977:IV

Interest Rate on Treasury
Bl1 Is (percentage
points)

+ .13

+ .33

+.20

Imports of Crude Oi1 and
Refined Petroleum
Products (millions of
barrels per day)

-.012

-.385

-.688

57
in the Consumer Price Index, and because the cost of crude oil is a
larger fraction of the wholesale price of petroleum products than of
the retail price* Decontrol would raise consumer prices by 0.4 percent
by the end of 1975, 1.6 percent by the end of 1976, and 1.8 percent by
the end of 1977.
In terms of rates of increase of consumer prices, decontrol would
add just under 0.5 percentage points to the inflation rate during the
last quarter of 1975, just over I percentage point to the 1976 inflation rate, and about 0.25 of a point to the 1977 inflation rate. The
general inflation index (GNP deflator) behaves in much the same way as
the Consumer Price Index.
Decontrol would significantly reduce growth in production below
what CBO projects would occur if controls are retained. Decontrol
would reduce real GNP by about 1.9 percent by the fourth quarter of
1977. CBO further estimates that the rolls of the unemployed would
swell by about 0.5 percentage points or 450,000 workers by the end of
1976 if controls are not continued, and by 0.6 percentage points or
nearly 600,000 workers by the end of 1977. The unemployment rate,
projected as falling very slowly during 1977 even with decontrol,
would stay practically unchanged at a level above 7 percent if immediate decontrol took place.
GNP in current do Ilars would not change much. The higher prices
would just slightly outweigh the reduced levels of production for most
of the period.
However, decontrol would noticeably affect the federal budget. Tax
receipts would rise substantially at first, largely because of the increased corporate tax payments by oiI companies. In late 1975 and
throughout 1976, these inflows would more than offset the falling receipts from individual income taxes, the higher payments for unemployment benefits, and the reduced tax collections from nonoiI corporations.
But by the end of 1977 the weakened economy would have its usual deleterious effects on the federal budget, and the deficit would be about
the same despite the higher oil company profits. To some extent, however, these figures may give an excessively optimistic impression of
the effects decontrol would actually have on the budget because the
analysis assumes unchanged federal expenditures. If some categories of
government spending (such as defense purchases of oil and food stamps)
were escalated to allow for the higher prices, the short-run beneficial effect on the deficit would be muted.
Table 9 also shows CBO's estimates of the effects of decontrol on
the retail price of refined petroleum products. The peak effect would
be about $.07 per gallon, though this would not develop until the
second quarter of 1976, according to CBO f s assumptions about how quickly

58
the oil companies would pass through the higher costs of crude oil.
This differential effect between the decontrolled price and what the
price would have been if controls were continued dwindles to about
$.06 per gallon by the end of 1977. (Prices would have been rising in
1977 even if controls were continued, because controlled old oil naturally was replaced by higher-priced new oil.)
Only part of the total effect of higher oil prices on the aggregate price indices can be directly accounted for by higher energy costs.
As energy costs raise the consumer prices of goods and services, workers
find the purchasing power of their wages eroded. They then try to recoup at least part of this loss by demanding higher wages. CBO estimates decontrol would result in a wage rate increase of about 0.5 percent. Given that prices would be nearly 2 percent higher, real wage
rates (that is, wages corrected for price increase) would fall by nearly
1.5 percent in spite of the wage increases.
Immediate decontrol would set in motion a rather complex chain of
events in the financial markets. The precise channels are described in
the next section of this chapter; Table 9 summarizes CBO f s estimate of
the financial reverberations from decontrol's estimated net impact on
the interest rate on three-month Treasury bills. It will be noted that
the upward pressure on interest rates peaks in late 1976, and is receding thereafter.
How Decontrol Affects the Economy
The preceding section summarized CBO f s estimates of the effects of
immediate decontrol without explaining the mechanisms by which the
shock of higher oil prices is transmitted to the national economy.
This section explains the linkages between higher oil prices, higher
prices generally, changes in spending by consumers and by oil companies,
and financial market changes.
The effects of higher oil prices on the aggregate price indices
are the easiest to reckon. Table 10 details CBO f s assumptions about
the behavior of refiners' acquisition costs of crude oil between now
and the end of 1977. As explained earlier, a $1.50 OPEC increase and
removal of the import duty is assumed in either case. It will be seen
that the maximum effect on crude oil prices would amount to just less
than $3.00 and would be felt in the middle of 1976.
How much does a $3.00 per barrel increase in the price of crude
oil contribute to the aggregate price indices? This calculation can be
made in two simple ways. Given total domestic consumption of crude oil
(including natural gas liquids) of about 5.3 billion barrels per year
(about 14.5 million barrels per d a y ) , the nation's oil bill would rise

59
TABLE 10—EXPECTED REFINERS' ACQUISITION COSTS OF
CRUDE OIL UNDER CONTROLS AND DECONTROL
(dollars per barrel)

Average Domestic Oi1
with
with
Controls Decontrol

Average of All Oi1
with
with
Controls Decontrol

Quarter

Imported Oi1

1975: 1
19751 1
1975: V

$13.44
13.61
13.52

$8.30
8.54
8.68

$ 8.30
8.92
10.56

$ 9.84
10.08
10.17

$ 9.84
10.35
11.47

1976:
1976:1 1
1976: 1 1
1976:1 V

14.27
14.27
14.27
14.27

9.19
9.31
9.39
9.48

12.16
13.56
13.72
13.72

10.77
10.88
10.96
1 1.04

12.81
13.78
13.89
13.89

1977:IV

14.27

9.79

13.72

11.32

13.89

Source:

Congressional Budget Office.

60
by about $16 billion per year. If output were unchanged, the general
price level (GNP deflator) would be about I percent higher.
The effect of an increase of $.069 per gallon in the price of petroleum products also can be traced. The most recent data from the U.S.
Bureau of Labor Statistics show that the average retail price of a
gallon of regular gasoline is $.591. Other petroleum products, which
are less expensive to refine and which are taxed less heavily, bear far
lower prices. If by the second quarter of 1976, the average price
per gallon of all petroleum products were $.59 with controls in force,
then the $.069 increase would represent a 13.8 percent increase. Gasoline, motor oil, and home-heating oil alone have a weight of approximately 4.5 percent in the Consumer Price Index. Considering the
indirect effects on transportation costs, petrochemical products, and
the cost of generating electricity, the total direct effect of oil in
the CPI is probably about 8 percent. A 13.8 percent rise in 8 percent
of the index implies a I.I percent rise in the entire C P I — a number
that agrees remarkably well with the preceding one.
Of course, this first round of price increases would be magnified
somewhat by induced increases in other energy prices, although prices
of competing fuels might take some time to react. For example, under
the assumptions detailed in the next section of this chapter, CBO estimates that the induced rise in the price of unregulated natural gas
would add roughly $| billion to the nation's energy bill in the fourth
quarter of 1976, and $3 billion in the fourth quarter of 1977. This
would add an additional 0.1 percent to the price level at the end of
1976 and 0.2 percent at the end of 1977. In addition, CBO has assumed
that decontrol would cause very small and very gradual increases in the
costs of other energy sources, such as coal and electricity.
Higher energy prices raise the cost of virtually every commodity
and service consumed. Given the well-established tendency for wages
to rise with prices, these energy cost increases probably would initiate
a wage-price spiral that would magnify the initial impact of decontrol
on aggregate price indices.
Since consumers cannot easily reduce their use of gasoline or
heating oil when the price rises, higher fuel prices force consumers to
spend more of their incomes on energy. This leaves less income to spend
on other goods and services, so the demand for other products drops and
real output and employment fall. Offsetting this in part is the
increased flow of profits to oil companies, which would result from the
decontrol of oil prices. If these funds were then spent on goods and
services, the employment-reducing effects of higher oil prices would be
largely offset.

61
Would they be spent? Tracing where the oil company profits would
be likely to go is not simple. Some profits no doubt would be distributed to stockholders in the form of higher dividends. While stockholders would certainly spend some of these dividends, it is likely
that much would be saved. Investment might rise, although this is somewhat doubtful since the price at which newly discovered oil can be sold
would not necessarily be raised by decontrol. The remainder of the
funds—which may be the great majority—probably would be used to
finance planned investment projects through retained earnings rather
than through loans from banks or issues of new securities. This reduced demand for corporate borrowing would, given an unchanged monetary
policy, ease pressures on interest rates somewhat. With considerable
lag, spending on business fixed investment and residential construction
would be increased.
Overall, it seems safe to assume that during 1976 and 1977 the loss
of purchasing power of consumers would reduce total spending by far more
than the increased flow of funds to oil companies would increase it.
Much of the drop in aggregate demand would be temporary, but "temporary"
in this context could easily mean two or three years.
While it was just suggested that higher oil company profits might
hold down interest rates, Table 9 shows interest rates rising. This is
because higher prices would lead to reduced production in still another
way. If the Federal Reserve System adhered to the same target growth
rate for the money supply despite the higher prices caused by decontrol,
the real value of the money supply (the money stock deflated by some
broad price index) would decline. This would tighten credit conditionscountering and perhaps overwhelming the increased flow of corporate
profits. With the usual lags, real output and employment would be
depressed.
CBO f s estimates suggest that the implied reduction in the real
money stock would have stronger effects on the financial markets than
would the improved corporate liquidity picture within the time frame
considered, so that the net effect would be to push interest rates upward. Once again it should be noted that this tightening of credit
markets should be a temporary phenomenon: as decontrol hampered the
recovery, lowering real output, the need for cash balances would be
reduced. Interest rates should then be able to recede to the levels
they would have attained in the absence of decontrol. But, once again,
temporary effects are the ones which would dominate in 1976 and 1977 and
higher interest rates in those years would mean a scaling down of business plans for fixed investment, with corresponding harm to the recovery.

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Assumptions Underlying the Analysis
Measuring the economic impact of decontrol requires a number of
explicit assumptions about the probable behavior of the various agents
involved: the OPEC nations, oil companies, oiI consumers (including
households and businesses), the U.S. Government, and perhaps even the
U.S. Supreme Court. These assumptions can be no more than educated
guesses, and different assumptions lead to different estimates of the
importance of decontrol.
This section details the assumptions underlying CBO's analysis,
explaining the reasoning behind each, and how alternative assumptions
might alter the conclusions.
The Price of Imported Oil. Decontrol would permit the price of
old o i l — n o w fixed at $5.25 per barrel at the wellhead—to float up to
the world market price. CBO's assumptions about the future price of
imported oil—based on elimination of the special $2.00 per barrel
tariff and a $1.50 per barrel increase in OPEC prices—are spelled out
in Table 10. CBO's analysis assumes that the special import duties
would end whether or not price controls end. This should not be interpreted as a prediction, but rather as a device to separate the impact
of decontrol from the impact of removing the tariff. If the tariff
were to remain on the books, the impact of decontrol would be substantial ly greater.
The Reaction of Domestic Oil Prices. Given the path for imported
oil prices displayed in Table 10, what would happen to domestic oil
prices under decontrol?
It is conceivable that old oil prices would rise immediately to
parity with domestic uncontrolled oil. CBO does not expect this to
happen for two reasons. First, the decontrol debate may not reach
final resolution for several more months. Major oil companies presumably wish to avoid the disruption in their marketing activities that
would be caused by raising the price of old oil for a brief period and
then being forced to reduce prices if new controls were established.
The fact that domestic crude oil prices have not skyrocketed since controls expired on August 31 is in accord with this view. Second, the
depth of the current recession does not make this a propitious time for
a sharp rise in the price of gasoline.
But these arguments support only a delay in the price rise, not
its elimination or even reduction. Under the current system, the OPEC
cartel dictates the world price of crude oil. American crude oil can
remain cheaper only under price and export controls.

63
CBO has assumed that immediate decontrol would mean the end of the
two-tier system of oil pricing, but that the new uniform price of domestic crude oil would rise only gradually from the current blend price.
Specifically, it is assumed that wholesale prices of refined petroleum
products would reflect the full $.07 per gallon increase only in May,
1976, and retail prices would lag very slightly behind that. If this
assumption errs, it is probably by exaggerating the time it would take
for prices to rise. Shortening the period of the price increase would
somewhat magnify the macroeconomic effects.
Another important issue is involved in translating price rises for
crude oil into price rises for petroleum products at the wholesale and
retail levels. While price controls are in effect, wholesale and retail dealers are limited to strict penny-for-penny passthroughs of crude
oil costs. As a result, profit margins per gallon are about the same
now as they were in late 1973, and represent considerably less purchasing power given the inflation since then. If price controls expire, the
question is open whether the free market would enforce penny-for-penny
cost passthroughs as the Federal Energy Administration now is doing.
If wholesale and retail dealers tried to/reestabIish the percentage
markups at 1973 levels, the price increase at the retail level could
amount to $.11 to $.13 per gallon instead of the $.07 per gallon
increase assumed by CBO.
Price Rises for Other Energy Sources. Assumptions must also be
made about price movements for competing energy sources if controls on
domestic oil are eliminated. CBO f s analysis assumes that coal prices
would hardly be affected by the increased price of crude oil. No one
knows whether this optimistic assumption will prove to be true, but
there are several reasons for making it; principally, that the coal
industry now has considerable excess capacity, and that coal competes
primarily with residual fuel oil, which is selling very near the world
price even with controls.
Natural gas poses a much knottier problem. Gas in the interstate
market is regulated at several levels, and cannot react to higher oil
prices unless regulations are eased. Holding down the price of natural
gas without creating severe shortages becomes more and more difficult
as oil prices rise. While it is thus conceivable that decontrol of oil
prices would force some relaxation of price controls on natural gas,
CBO has not factored such an event into its calculations. The current
system for regulating natural gas is assumed to remain intact through
the end of 1977 whether or not oil prices rise.
However, a free market exists in intrastate natural gas, and it is
likely that some price reaction will be seen in this market. CBO has
assumed that prices of natural gas in the intrastate market would move
in response to higher oil prices, but that the movements would lag far

64
behind the oil price increases. Specifically, CBO f s analysis of decontrol assumes that within eighteen months after any increase in the
price of crude oil, the prices of approximately one-quarter of the natural gas consumed in this country would have risen by roughly two-thirds
as much as oil on a BTU basis. This implies that natural gas prices
would be about 23 percent higher by the end of 1977 if controls end
than if controls remain. It is possible that this exaggerates the reaction of natural gas prices. But the dollar magnitudes are so small
relative to those for the oil bill that even complete elimination of
the assumed corresponding changes in natural gas prices would not change
the economic impacts given in Table 9 very much.
Windfal I Profits. CBO's analysis of decontrol assumes no change
in government policies beyond decontrolling oil prices itself. One
change often discussed in connection with decontrol is a windfall profits tax, or a special tax on oil producers that is based on the amount
by which the wellhead prices of old oil rise above the $5.25 ceiling.
Most windfall profits tax proposals include "plowback" provisions that
return some of the tax revenues to 6iI producers in proportion to their
investment outlays.
A windfall profits tax would not change oil prices to consumers,
but would transfer some of the profits from oil companies to the U.S.
Treasury. The U.S. Government would borrow less and oil companies
would borrow more, with little net effect on credit markets. If the
government returned some of these revenues to corporations, the federal
deficit would be larger, but the cash flow to corporations would be
correspondingly greater. The plowback could have significant macroeconomic effects only if it induced additional investment, or if most
of it were paid out to stockholders in the form of higher dividends.
As explained earlier, CBO would not expect much stimulus to aggregate
demand from these sources during 1976 or 1977.
Tax Offsets to Decontrol
If the government chose to return part or all of the increased oil
bill, through tax cuts to consumers, the effects on output and employment would be blunted, and might even be entirely eliminated. However,
restoration of consumer purchasing power could slightly exacerbate the
original inflationary impact of the higher oil prices, and add somewhat
to the wage-price spiral. This section estimates the size and form of
the personal income tax reductions that would be necessary to offset
the effects of decontrol on real output, and the additional inflation
these tax cuts would cause.
A series of very substantial tax cuts would be required to restore
the levels of real GNP projected in Table 4 if oil price controls were

65
to be dropped immediately. CBO estimates that a reduction in withholding rates amounting to approximately $15 billion to $17 billion initially
(and increasing as the economy grows) sometime in the fourth quarter of
1975 and/or the first quarter of 1976 would be necessary to offset the
direct effect of higher oil prices.
While this would return roughly the entire increase in the fuel
bill to consumers, it would not be sufficient to cancel the entire contractionary impact of decontrol. The wage-price spiral induced by decontrol would be a further drag on the economy during 1976 and 1977.
CBO estimates that small tax cuts, amounting in total to perhaps $8
billion to $10 billion and distributed among the remaining three quarters of 1976 would cancel out these additional indirect effects of decontrol on real output.
Naturally, this much fiscal stimulus would exact some price on the
inflation front. CBO estimates that this fiscal package would add a
negligible amount to the inflation rate in 1976, approximately 0.2 percentage points to the inflation rate in 1977, and about 0.3 in 1980.
The cost to the federal budget deficit could be reduced if the
Federal Reserve System supplied more money. As has been explained, decontrol would push interest rates up somewhat initially by reducing the
real value of the money supply by more than it reduced real output.
However, the substantial tax cuts that would be required to offset the
effects of decontrol on real output would push interest rates up still
higher. CBO has therefore investigated a combined fiscal-monetary offset to decontrol in which the Federal Reserve System would supply
enough money to prevent any rises in interest rates. If the Federal
Reserve System were willing to accommodate both decontrol and fiscal
policy in this way, CBO estimates that the initial tax reduction in
late 1975 or early 1976 would have to be only about $10 billion to $13
billion; the remaining tax cuts distributed throughout 1976 would have
to amount only to $6 billion to $9 billion. The long-run inflationary
consequences of this combined fisea I-monetary package would be approximately the same as those of the tax offsets alone.

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