Some say history repeats itself, others say it merely rhymes. Going by the headlines in recent months, it certainly feels like the US economy is in for some deja vu moments in the coming days as far as oil output cuts and rising inflation are concerned.
To understand this, we need to go back 50 years.
It was in October 1973 that members of the Organization of Arab Petroleum Exporting Countries (OAPEC) proclaimed an oil embargo on the United States. The embargo was in response to America’s support for Israel during the Yom Kippur War, and would go on to last until March 1974. In the aftermath, crude oil prices quadrupled, from around $3 per barrel to nearly $12 globally.
The embargo “triggered one of the most devastating periods of inflation in American history” -- a period that would come to be known as the ‘Great Inflation’ of the 1970s.
US CPI inflation doubled in 1973 to 6.2%, and rose again to 11% in 1974, before moderating to 9.1% the following year. It again rose sharply towards the end of the decade, hitting a peak of 13.5% in 1980.
Coming back to the present, we can see many similarities in the predicament that the US finds itself in today. For example, last year saw retail inflation in the US hit a 40-year high of 9.1%. Subsequently, it declined slowly to 3% by June this year, leading to sighs of relief in both policy circles and stock markets. However, since then, it has again started rising – first to 3.2% in July and now to 3.7% for August.
The latest march is fueled by higher crude oil prices. With no strategic oil reserve to counter the production cut put in place by major producers like Saudi Arabia, crude oil prices have risen steadily from the low 70s three months ago to over $90 per barrel now.
While there is no oil embargo by Middle Eastern countries this time, the up-move in crude prices is being driven by production cuts implemented jointly by Saudi Arabia, other OPEC players and Russia. The motivation this time is profit, unlike 1973, when it was outrage over the Yom Kippur war, but the impact may be just as devastating for the US, and global, economy.
The current bout of inflation, which began in 2021, was initially dismissed as ‘transitory’ by the US central bank, and to a large extent, by market participants.
As late as August 2021, yields on the two-year treasury bond of the US government was just 0.2% per year. The yield is a reflection of what the market expects the average interest rate to be over the tenure of the bond.
Hence, as of August 2021, the market expected interest rates to remain in the 0.25% range for the next two years.
However, as it became clear that the inflation was not ‘transitory’ and the US Fed too started raising interest rates, yields started climbing and hit a peak of 4.5% by November 2022.
It then started falling in March this year on hopes that inflation has been successfully tamed, and the Fed would start cutting interest rates by the end of this year, or, at the latest, early next year.
However, since May, it has become more and more clear that inflation is stickier than expected, and that the genie is not going back in as easily as it came out. And with this, hopes of a rate cut any time soon have also receded. This has been reflected in a renewed upsurge in bond yields, which have now hit 5.13%, which is similar to the peak hit during the global financial crisis 15 years ago.
Saudi Arabia’s thirst for profits, Russia’s invasion of Ukraine and the introduction of new, debt-funded trillion-dollar welfare programs by the Biden administration have all contributed to higher inflation and oil prices.
However, there is also a more long-term cause that many often ignore: The ultra-loose monetary policy followed by the US central bank since the recession of 2008-2009. Interest rates were kept near zero, while trillions of dollars were injected into the economy via quantitative easing.
This influx of easy money into the system laid the groundwork for an eventual surge in inflation. However, consumer prices remained relatively stable in the decade following the Great Recession. It wasn’t until the Covid-19 pandemic struck in 2020 that inflation pressures truly started mounting.
In response to the economic lockdowns enacted to contain the virus, the Fed again cranked up the money printing presses. Congress also approved trillions in fiscal stimulus and relief spending. While these measures averted a far worse economic crisis, they added fuel to the inflation fire. Still, the Fed initially maintained that pricing pressure would be “transitory”. The thesis was that inflation would abate once pandemic-induced supply chain kinks were ironed out.
It took Russia’s invasion of Ukraine to finally bring home the seriousness of the situation to the central bank officials. Energy and food commodity prices soared after the invasion disrupted vital supply chains.
Being one of the world’s largest oil and natural gas exporters, Russia supplies around 10% of global oil output. It’s also the top natural gas exporter, accounting for around 20% of total global supply. Sanctions limiting these exports, self-imposed cuts by Russia, and avoidance of Russian energy by Western nations have significantly reduced global supply.
Brent crude prices that were around $90 per barrel in February spiked to over $120 in the aftermath of the invasion.
Besides energy, Russia and Ukraine are vital suppliers of agricultural commodities. Together they account for around 30% of global wheat and 20% of corn exports. Grain shortages resulting from the war have driven world food prices up by nearly 50% this year according to the UN Food and Agriculture Organization. Combined with higher energy bills, elevated food costs are squeezing consumer budgets from all sides.
Inflation and the US Dollar
The US dollar rose to its current position of pre-eminence in the aftermath of World War 2, supplanting the British pound as the global reserve currency under the Bretton Woods system.
However, decades of rising fiscal deficits and mounting government debt levels have steadily eroded the foundations underpinning dollar dominance. The offshore dollars accumulated during periods of US current account deficits are like an interest-free loan to America. But chronically high inflation will chip away at global confidence in the dollar.
For example, the last time the dollar’s reserve status faced a serious challenge was in the early 1970s. Years of spending on Vietnam War and Great Society programs drove up inflation and ballooned deficits. In 1971, President Nixon suspended gold convertibility to stem outflows, formally ending the Bretton Woods system.
In the years following, elevated inflation eroded the dollar’s purchasing power. America’s share of global reserves declined from over 80% in the late 1960s to under 50% by 1978. The run-away inflation was brought under control only after US interest rates were raised to 21.5% in 1981.
While the share of the greenback did come back to a high of around 71% by the turn of the millennium, it has seen a steady decline since then. The most accelerated decline, however, has been witnessed since 2020, with countries like China are busy reducing their holdings of US dollars and dollar-denominated assets such as treasury bonds. By the end of 2022, the share of US dollar in global forex reserves is estimated to have come down to 58.3%.
The decline is being driven by years of quantitative easing that have stoked worries about currency debasement. If high inflation comes back to haunt the US economy, the drumbeat of concerns about dollar dominance growing faint may grow too loud to ignore. Countries such as India, China, South Africa and Russia have started trading with each other without using the dollar – in local currencies.
Going by history, reserve currencies tend to have a life cycle of around a century, before fiscal abuse leads to dethroning. The pound sterling reigned from the mid-1800s until the early 1900s when World War I drained British finances. The dollar has now been the dominant reserve currency for nearly a century since 1925, when it overtook the pound.
With deficits at sustained postwar highs and inflation resurgent, the dollar could be nearing the end of its own lifespan as a global reserve. One of the things going for the dollar has been the lack of alternatives. The Euro has stumbled from crisis to crisis. China’s renminbi lacks convertibility and transparency. Gold is too cumbersome for modern currency needs. Cryptocurrencies have also not lived up to their promise.
This means the greenback could hold much of its reserve status for the foreseeable future, while slowly bleeding influence in favor of a slew of competitors.
Meanwhile, what the US policymakers should worry about is that prolonged inflation would accelerate that erosion of dollar dominance, and that monetary policy alone will not be able to tame inflation or avert stagflation. To retain economic preeminence, America must get its fiscal house in order, and reduce its yearly fiscal deficit from around 5.3% of the GDP, or around $1.4 trillion, to more manageable levels.