Note on Oil, the Dollar, and Inflation

February 18, 2015

The genesis of this comment lies in the 1970s, not because of similarities between then and now but rather because the current period seems on anecdotal observation to be an inversion of then.  There were two oil price shocks in the 1970s, a quadrupling of crude in early 1974 and a second sharp upward thrust in 1979 seemingly associated with the Iranian Revolution.  CPI inflation, which had averaged 1.3% per annum between the end of 1951 and end-1964, spiked as high as 12.3% during the first oil price shock and never got lower than 4.9% in the remainder of the 1970s.  Oil took much of the blame for the erosion of price stability.  Policymakers and analysts varied between viewing oil either as a totally exogenous non-monetary development or a main cause feeding the broader rise in inflation. 

Dollar weakness in the 1970s was framed as a separate problem, caused in part by the relatively higher U.S. inflation rate.  There were formal devaluations of the U.S. currency in 1971 and early 1973, followed by a considerable amount of additional depreciation when the international monetary system switched to  flexible dollar exchange rates after March 1973.  Only late in the period was dollar depreciation and accelerating U.S. inflation framed as reinforcing sides of a vicious cycle.  To stop inflation, one also had to stop the falling external value of the dollar, as it was realized that exchange rate erosion was a cause as well as an effect of the lack of internal price stability. 

In fact, it’s true as well that the spike in oil prices was not just a cause of rising inflation but also the result of macroeconomic policies that promoted excessive aggregate demand.  A world that was not conducive to a leap in oil costs around the middle east wars in 1956 and 1967 was so after the Yom Kippur War.  Even then, it was wrong to view the dynamics of U.S. inflation as being a self-contained system closed to the ebb and flow of what was happening in other economies.  Mid-1977 inflation was far higher than current levels in a broad cross-section of the world.  Here’s a sample from June that year: U.S. (6.8%), Canada (7.8%), Japan (8.5%), Hong Kong (6.3%), Australia (13.4%), Great Britain (17.7%), Italy (20.0%), West Germany (4.0%), France (10.2%), Sweden (11.7%), Denmark (10.7%), Spain (23.4%), Argentina (148.8%), Mexico (32.5%), and Brazil (44.1%).

Imports now comprise 16% of U.S. GDP, a much higher share than back in the 1970s, so U.S. inflation has become a lot more exposed to price trends abroad.  The sharp decline in oil prices since last June reflects weak global demand for energy but also highlights a global phenomenon of prolonged disinflation and, in some places, outright deflation.  The United States is not fully insulated from these forces.  Dollar appreciation adds torque to this process.  A Fed policy that only attempts to coordinate credit policy with U.S. economic trends is bound to be too restrictive in present circumstances.  Quantifying the bias, and even determining if the perceived lessons of the 1970s might apply but in reverse to now, would require considerable empirical exploration and is beyond scope of this short note.  But when Fed officials talk about normalizing policy only gradually, they seem to be taking some account of the dollar, oil and what’s happening to price trends in other parts of the world.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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