It's Not Your Dad's Oil Story

We have all the telltale signs of an inflation breakout: a big jump in oil and energy prices; an increase in the price of gold, often an inflation hedge; a low unemployment rate (5.1 percent in September, despite Katrina) that could push up wages. To anyone old enough to remember, the situation seems eerily reminiscent of the 1970s, when oil prices soared and inflation reached peaks of 12.3 percent in 1974 and 13.3 percent in 1979.Well, folks, it ain't gonna happen this time.

Here are three reasons: (1) The Federal Reserve won't let it happen. The Fed would tolerate a recession before again permitting inflation to go bonkers. (2) The economy has become vastly more competitive since the 1970s. It's harder for companies to raise prices, because they face imports or low-cost domestic rivals. (3) Productivity has also improved since the 1970s, helping companies absorb some cost increases without raising their prices ("productivity" means "efficiency" and is measured by output per hour worked).

Granted, the recent inflation news has been abysmal. In September, the Consumer Price Index (CPI) was up 4.7 percent from a year earlier, the largest 12-month gain since June 1991. But the overwhelming cause was the explosion of energy prices, not a general rise of most prices. Economist James Hamilton of the University of California at San Diego cites this revealing factoid: even if no prices outside energy had increased, the CPI would still have risen 2.7 percent. In the past year, energy prices (mostly gasoline, heating oil and natural gas) are up 34.8 percent. Gulp.

Because we think that higher oil prices caused double-digit inflation in the 1970s, we fear it could happen again. The trouble with this impeccable logic is that the underlying facts are wrong. High oil prices didn't cause the 1970s' double-digit inflation; they simply made it slightly worse. Look again at those peak CPI numbers: 12.3 percent for 1974 and 13.3 percent for 1979. Now, look at the figures without the effect of energy prices: 11.7 percent (1974) and 11.1 percent (1979). Or consider this: in the 1960s, well before any oil "shock," inflation went from 1 percent to 6 percent.

"People make a mistake when they attribute inflation [mainly] to oil prices," says Hamilton. "It was what the Federal Reserve was doing before the oil shocks that made for inflation." What the Fed was doing was following easy money and credit policies. The economy repeatedly "overheated," creating a stubborn wage-price spiral and pervasive inflationary psychology. Countless economists, left and right, have concluded that oil prices were not the principal inflation culprit.

Still, the myth endures. It's apparently indestructible. Why is this? One reason is that it's a simple story; it's easy to understand and remember. Better yet, it puts most blame on foreigners--those "greedy" oil exporters. It plays to our victimhood. Inflation wasn't our fault; it was what others did to us. A second reason is that we confuse a rise in our "cost of living" with the onset of higher inflation. Although the two concepts are related, they're not identical.

Of course, if all prices rise 10 percent, then your cost of living has also risen 10 percent. That's a general inflation: most prices increase. But if only a few prices rise--say, gasoline and heating oil--and others don't fall, your cost of living also goes up. That's not a general inflation. Similarly, your cost of living can go up if you decide a decent life requires more stuff. "Luxuries" become "necessities." In 1970, 20 percent of Americans saw a second family car as a necessity; by 2000, that was 59 percent, reports Alain de Botton in "Across the Board" magazine.

The high inflation of the 1970s was mostly self-inflicted. It was the consequence of bad economic ideas. What prompted the Fed to follow easy-money policies was the belief--then dominant among mainstream economists--that there is a stable "trade off" between inflation and unemployment. In effect, you could juice the economy, and you'd get a big drop in unemployment and a slight rise in inflation--say, 3 percent unemployment with 4 percent or 5 percent inflation. But the unemployment and inflation rates, once reached, wouldn't budge. It seemed like a good deal. Unfortunately, the theoretical bargain didn't work in practice. The perverse result was both higher inflation and higher unemployment. By 1980, wages and fringe benefits were rising at nearly 11 percent annually. Only the brutal 1981-82 recession, with peak unemployment near 11 percent, reversed the policy and the inflationary psychology.

In coming months, higher energy prices may recede--or they may filter into other prices, from plastics to pizza home deliveries. Inflation may temporarily worsen, but it will move permanently higher--say, from 2 percent to 5 percent--only if the Fed permits it to move higher. That is, if it pushes out so much money that it creates enough artificial demand to trigger a new wage-price spiral. In recent speeches, Fed officials pledge not to let that happen. Perhaps they underestimate the danger that higher energy prices will bring recession, but they seem to have read history and made their choice.