The inflation surge of the 1970s is widely acknowledged to have been caused partly by insufficiently restrictive monetary policies following the 1973 oil “shock”. Are policy-makers similarly at risk of “accommodating” the inflationary impact of higher commodity prices now, as they simultaneously seek to minimise economic weakness caused by credit market woes?

The rise in oil prices in recent years has occurred in two distinct stages, which mirror the two shocks of the 1970s, although the primary driver has been emerging world demand for energy rather than supply disruption. The initial breakout from the range of the prior decade occurred between late 2003 and mid 2005, when prices rose from $35 to $65 a barrel (expressed in terms of today’s US consumer price level). A period of stability then ensued until early 2007, when prices embarked on a further surge to their recent peak above $140. For comparison, inflation-adjusted prices rose from $13 to $45 during the 1973 oil shock (caused by an Arab embargo on supplies to allies of Israel) and from $45 to a peak above $110 in 1978-79 (as the overthrow of the Shah led to sharp fall in Iranian exports).

A simple way of measuring the monetary policy response to an oil price change is to compare subsequent movements of short-term interest rates and headline consumer price inflation. As the chart below shows, average G7 short rates failed to keep pace with inflation following the 1973 shock – real rates were consistently negative over 1974-78. This policy response is now recognised to have been misguided: it allowed higher inflation expectations to become entrenched and did not avert a severe recession. By contrast, short rates were raised well above the level of inflation after the second shock of 1978-79, partly under the influence of hawkish US Fed Chairman Paul Volcker. Recession again ensued but the restoration of monetary discipline laid the foundations for a sustained decline in inflation during the 1980s.

How does recent experience compare with these episodes? The 2003-05 oil price rise was less dramatic than the 1973 shock and had a much smaller impact on headline inflation. As the chart shows, G7 short rates moved up in line during the shock and became significantly positive in real terms in 2006 as inflation fell back. On this basis, policy appears to have been broadly appropriate, although the Fed should arguably have been swifter to tighten in 2004-05 – low real rates contributed to the subsequent housing market bubble. The response to the more recent oil price surge has been less convincing. The Fed’s decision to prioritise credit market concerns and ease policy aggressively coupled with a larger rise in headline inflation than in 2003-05 has resulted in G7 real short rates becoming significantly negative. As in the mid 1970s, it is debatable whether policy laxity has served the intended purpose of supporting activity and it may have contributed to an unwelcome rise in inflation expectations.

It is possible to argue that G7 monetary policies are tighter than suggested by the level of real short rates because of the impact of the credit crisis on banks’ lending behaviour. However, the interest rate measure used in the chart is based on interbank rather than policy rates so partly incorporates current market dislocation. Moreover, any assessment of the global monetary stance must also include emerging economies, where banks are generally still lending freely and short rates are even further below inflation. Taking these considerations into account, there appears to be little scope for any early decline in global rates if inflation is to be returned to the low levels of the last decade. Indeed, a rise may be required – led by the US and emerging economies where real rates are heavily negative – to ensure sufficient monetary discipline.