1970's and oil price shocks

Everyone wants to go back to the 1970's to compare the current commodity oil price shock. The decade of the 1970's were a period of significant commodity shocks. Oil prices had twin price shocks in the 1970's. Grains had a shock with the poor harvest in Russia and rest of the world. The inflation rate had a significant shock and the US as well as many of the countries of the world went into a recession. On the surface it seems to be the same issue 35 years later. Yet, making those types of analogies is dangerous. Perhaps the only thing that we can say will be true is Stein's Law that “If something cannot go on forever, it will stop”.

The price gains in commodities will stop because the economy will adjust to the increase; however, the real issue for the 1970's inflation analogy is whether the price shocks in commodities will be monetized and will there be a wage (cost) price spiral that will fuel inflation. It is the link between the shock and the economy that will determine whether this will be a story with a different ending. The key issues are threefold:

1. The behavior of the monetary authorities. We have moved from trying to worry about multiple goals of inflation fighting and high growth to a critical focus on inflation targeting. Central banks are less worried about setting interest rates but trying to hit a target for the increase in prices. This is a vast improvement over the behavior of the 1970's when there was still a focus on Keynesian control If central banks follow their goal of inflation targeting there will less likelihood that this will be like the 1970's with entral banks first trying to help the real economy and then playing catch up with controlling interest rates. Unfortunately, we do not know what will be the creditability of these central banks during a prolong inflation. The bankers have not been tested during this scenario.
2. The sensitivity of the economy to the price shocks. The economy is less sensitive to the change in oil prices. It takes about 50% less oil for a dollar worth of GDP. There is less reliance on hevay industry than in the 1970's for the US; nevertheless, the key issue is the emerging market economic engine which is more driven by energy costs. Given a looser link between energy and the economy, the size for the price increase will have less of an impact. No doubt the increase has been significant and it will have a appreciable drag on economic performance, but for the same increase price gain the economy may be more resilient than would be the case during the 1970's.
   
3. The link between these price increases and inflation. The wage price link has fallen from what was th case during the 1970's. The more diverse economy means that wage-earners have less control over their earnings adjustment to inflation. The impact of globalization is that the the slack in the economy for wages is on an international level not just a country level. While wages are increasing in emerging markets, there is still slack in the economy that will cap the size of increases in all prices around the work. The issue will be what are the inflationary expectations embedded in the economy later this year. However, on a percentage increase, the rise in inflation is real. We have stated at a lower price level but so the absolute level of inflation may not match the increases in the 1970's.

The analogy with the 1970's may be a little too easy. yes, there are similarities but a close look at the stories between then and now show only a weak connection. We may face higher inflation but it will be a new story for a new century.