This Year's Rising Inflation Has Another Driver, Oil Is Definitely Not the Culprit

On Wednesday, July 29, 2020, U.S. President Donald Trump displayed an executive order he signed on an oil drilling platform operated by Double Eagle Energy Holdings LLC in Midland, Texas. Photo credit: Cooper Neill/Bloomberg via Getty Images

Since the U.S. and Israel launched a war against Iran, oil prices have continued to soar. In response, commentators, media reporters, and many economists have repeatedly echoed the old refrain: rising oil prices will push up inflation. While this view is widely accepted, its core logic is actually flawed.

Rising oil prices cause relative price changes—that is, oil prices increase compared to the prices of other goods and services. However, an increase in the relative price of oil does not raise overall inflation. Only an increase in the money supply can push up overall inflation. Ultimately, inflation is a monetary phenomenon, regardless of time or place.

People often blame the inflation of the 1970s and early 1980s in the U.S. and other regions on the two oil crises of 1973–1974 and 1979–1980. The first oil crisis was triggered by the Yom Kippur War, during which Arab oil-producing countries cut oil supplies to support Israel. The second crisis stemmed from the Iranian Revolution and subsequent conflict with Iraq, which led to a halt in Iranian oil exports. Both crises caused sharp increases in oil prices. Mainstream arguments claim that the surge in oil prices directly caused high inflation. Although this view is widely accepted and frequently repeated, it does not hold up under scrutiny.

While inflation occurred in some countries during each oil crisis, this does not mean that rising oil prices directly caused inflation. In the U.S., the inflation of 1973–1975 and 1979–1981 was driven by prior rapid growth in the broad money supply. Measured by M2 (a term economists use to refer to the money supply in the economy), both periods saw significant expansion two to three years before the inflation spikes. (In short, M2 includes all circulating cash, checking accounts, savings accounts, and time deposits—financial assets with lower liquidity.)

In fact, during the first inflation cycle, U.S. M2 grew at a double-digit annual rate from July 1971 to June 1973, averaging 12.5% per year—about twice the rate needed to achieve the roughly 2% inflation target. Unsurprisingly, the consumer price index (CPI) inflation rate rose from 3.7% in January 1973 to a peak of 12.3% in December 1974, with an average inflation rate of 8.6% over those two years. Similarly, from January 1976 to December 1978, U.S. M2 grew at an average annual rate of 11.2%, directly fueling the second round of inflation: the average inflation rate jumped from 7.6% in 1978 to 11.3% in 1979, 13.5% in 1980, and 10.3% in 1981. In short, the high inflation during both oil price surges was already set in motion before the crises occurred.

Japan’s performance during the two oil crises was markedly different from that of the U.S., providing valuable insight into the relationship between money growth and inflation. The problem in the U.S. was that, before both crises, it failed to effectively control money growth. Japan, however, learned from the first oil crisis: prior to that crisis, Japan allowed unchecked growth of the money supply; but when the second oil crisis hit, Japan was determined not to repeat the mistake, and the results were significant.

In August 1971, U.S. President Nixon announced the end of the gold “window,” ending the U.S. commitment to sell gold to foreign central banks at $35 per ounce. This move caused sharp appreciation of several foreign currencies against the dollar, including the yen. Japan was concerned that this change would severely impact its export-driven economy, so it adopted an expansionary monetary policy, lowering interest rates and allowing the money supply to grow rapidly—between June 1971 and June 1973, Japan’s M2 grew at an average annual rate of 25.2%. This surge in money supply set the stage for rising asset prices, economic growth, and inflation. Indeed, Japan’s inflation rate jumped from 4.9% in 1972 to 11.6% in 1973, and soared to an astonishing 23.2% in 1974.

After the crisis, Japanese authorities implemented M2 growth controls in July 1974. Over the next decade, M2 growth gradually slowed, and during the critical window from January 1976 to December 1978, the average annual growth rate was only 12.8%, halving the pre-crisis level. As a result, when the second oil crisis occurred, overall consumer price inflation remained moderate—rising from 4.2% in 1978 to a peak of 8.2% in 1980, then falling back to 4.9% in 1981. In other words, despite rising relative oil prices, overall inflation remained relatively subdued. This case powerfully demonstrates that the root cause of inflation is changes in the money supply, not fluctuations in oil prices.

Turning to the current U.S. economy, if the Trump administration’s fiscal deficits continue to be financed through the banking system and monetary markets, the growth rate of the money supply will keep accelerating, and overall inflation will rise accordingly. However, if broad money growth is controlled, increased spending on oil and gasoline will be offset by reductions in other expenditures, thereby suppressing overall inflation. (Wealth Chinese)

Authors: Steve H. Hanke, John Greenwood

Translator: Zhong Huiyan - Wang Fang

Steve H. Hanke is a professor of applied economics at Johns Hopkins University. His latest book, Making Money Work: How to Rewrite the Rules of Our Financial System, co-authored with Matt Sekerke, will be published by Wiley in 2025. John Greenwood is a researcher at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise in Baltimore, Maryland.

Opinions expressed in the commentary on Fortune.com are solely those of the authors and do not necessarily reflect the views or positions of Fortune magazine.

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