Following the initiation of the U.S.-Israeli conflict against Iran, oil prices have seen a significant increase. Consequently, a familiar argument has resurfaced among commentators, journalists, and many economists, asserting that elevated oil prices will inevitably drive up inflation. However, this widely held belief is inaccurate.
A surge in oil prices leads to a shift in relative prices, meaning oil becomes more expensive compared to other goods and services. Nevertheless, this change in the relative price of oil does not cause a general rise in the inflation rate. Inflation can only occur if there is an increase in the money supply. Ultimately, inflation is fundamentally a monetary phenomenon.
It is commonly stated that the inflation experienced in the United States and other countries during the 1970s and 1980s was a direct result of the oil crises of 1973-74 and 1979-80. The first crisis was triggered by the Yom Kippur War, which led Arab oil-producing nations to reduce oil exports to countries supporting Israel. The second crisis stemmed from the Iranian revolution and the subsequent conflict with Iraq, disrupting oil exports from Iran. Both events caused substantial increases in oil prices. The prevailing narrative suggests a causal link between these oil price surges and the observed inflation. Despite its widespread acceptance and repetition, this narrative lacks factual support.
While it is true that inflation occurred in some countries during each oil crisis, this does not imply that the oil price surge was the cause. In the U.S., the inflationary periods of 1973-75 and 1979-81 were preceded by significant increases in the broad money supply, specifically the growth of M2, which economists define as the total money supply in the economy, in the two to three years leading up to each inflationary episode. (M2 encompasses all physical currency and coins in circulation, along with checking accounts, and less liquid investments like savings accounts and certificates of deposit.)
Specifically, in the first instance, the U.S. M2 experienced sustained double-digit growth from July 1971 to June 1973, averaging an annual rate of 12.5%. This rate is approximately double the monetary growth rate typically associated with an annual inflation rate of around 2% in the U.S. Unsurprisingly, the annual headline Consumer Price Index (CPI) inflation rose from 3.7% in January 1973 to a peak of 12.3% in December 1974, averaging 8.6% over those two years. Similarly, between January 1976 and December 1978, M2 growth averaged 11.2% annually. This directly contributed to a subsequent surge in inflation, with the average rate increasing from 7.6% in 1978 to 11.3%, 13.5%, and 10.3% in 1979, 1980, and 1981, respectively. In essence, the inflationary spikes that coincided with the oil price surges were already set in motion well before the oil crises began.
Japan’s experience during these two oil crises differed significantly from that of the United States, offering valuable insights. It convincingly illustrates the relationship between money supply growth and inflation. While the U.S. failed to control money growth prior to both oil crises, Japan’s authorities learned from their experience during the first crisis. Before the initial crisis, Japan had allowed its money supply to grow unchecked. However, when the second oil crisis occurred, Japan’s resolve to avoid repeating its past mistake proved effective.
In August 1971, President Nixon announced the closure of the gold “window,” ending the U.S. authorities’ commitment to sell gold to foreign central banks at $35 per ounce. This resulted in a sharp appreciation of many foreign currencies, including the Japanese yen against the U.S. dollar. The Japanese feared this move would severely impact their export-driven economy. Consequently, they implemented an expansionary monetary policy, lowering interest rates and allowing money growth to accelerate to an average of 25.2% per year between June 1971 and June 1973. This rapid increase in money growth set the stage for a surge in asset prices, economic expansion, and inflation. Indeed, inflation rose from 4.9% in 1972 to 11.6% in 1973 and a remarkable 23.2% in 1974.
Following the first crisis, the Japanese authorities introduced a plan to control M2 growth, commencing in July 1974. The M2 growth rate gradually decreased over the subsequent decade, averaging just 12.8% during the crucial period of January 1976 to December 1978, effectively halving the M2 growth rate observed before the first oil crisis. As a result, when the second oil crisis occurred, the overall CPI saw only a modest increase, rising from 4.2% annually in 1978 to a peak of 8.2% in 1980, and then to 4.9% in 1981. In other words, while relative prices increased, overall inflation remained relatively contained. This provides a compelling demonstration that changes in the money supply, rather than changes in oil prices, are the drivers of inflation.
Turning to the current situation in the U.S., if the Trump administration’s budget deficits continue to be financed through the banking system and money market funds, the rate of money supply growth will accelerate, leading to an increase in headline inflation. However, if the growth rate of the broad money supply is managed effectively, increased spending on oil and gasoline will be counterbalanced by reduced spending on other goods, thereby curbing overall inflation.