Inflation and energy price shocks: lessons from the 1970s

The Yom Kippur war in 1973 and the Iranian revolution in 1979 triggered large oil-price increases that fuelled high and persistent inflation in advanced countries. There is a broad consensus that a weak monetary policy response, in the form of late tightening or early loosening, was one of the main causes for the failure to keep inflation under control after the 1973 shock. This failure is crucially tied to the end of the Bretton Woods era in 1971, when the fixed exchange rate regime and the currency peg to gold were abandoned, and monetary policy lost a consolidated frame of reference. A new framework – based on the commitment by independent and credible central banks to achieve clear quantitative inflation targets – would only be established in the subsequent two decades. Monetary policy conduct alone, however, does not fully explain the persistence and heterogeneity of inflation across advanced economies. Other institutional factors played a role ‒ most importantly, the lack of central bank independence, the structural features of the labour market, and fiscal policy rules which turned out to be at odds with price stability. A structural VAR-based analysis confirms and quantifies the role these factors played in shaping inflation. Nowadays, the institutional context has evolved considerably, mitigating the risk of inflation staying high for as long as they did in the 1970s. Ensuring that the current institutional context continues to support price stability remains key in limiting inflation persistence.