Economic Highlights of 1973

Richmond Fed (PDF): FINANCIAL HIGHLIGHTS OF 1973

As the demand for credit rose in the third quarter, the Federal Reserve kept a tight rein on the available supply. M1 growth slowed by nearly two full percentage points over the period, contributing to unusually high short-term interest rate levels. Monetary policy was also directed toward controlling the growth of bank credit through the price mechanism. Although the Fed sought to moderate the pace of economic activity, it did not intend to bring it to a halt and accordingly was careful not to choke off completely the available supply of credit. For example, the suspension of interest rate ceilings on CD’s enabled banks to continue to obtain funds for making loans and investments. Late in the third quarter, when business loan growth at commercial banks slowed, and it was evident that M1 growth for the third quarter would be slower, the Fed was not unwilling to accept a downturn in interest rates and somewhat faster M1 growth over the fourth quarter. This adjustment was consistent with moderate monetary expansion and in no way indicated a retreat from the battle against inflation.

During the fourth quarter, monetary policy was designed to give the Federal Reserve a high degree of flexibility in responding to the effects of the Arab oil embargo over the ensuing months. Because of the large measure of uncertainty associated with the potential impact on the economy of the embargo, the Federal Reserve made no overt attempt either to ease or to tighten policy.

Federal Reserve History: Oil Shock of 1973–74

As Arthur Burns, the chairman of the Federal Reserve at the time, explained in 1974, the “manipulation of oil prices and supplies by the oil-exporting countries came at a most inopportune time for the United States. In the middle of 1973, wholesale prices of industrial commodities were already rising at an annual rate of more than 10 per cent; our industrial plant was operating at virtually full capacity; and many major industrial materials were in extremely short supply” (Burns 1974). In addition to these cost pressures, the U.S. oil industry had a lack of excess production capacity, which meant it was difficult for the industry to bring more oil to market if needed (Alhajji 2005). Thus, when OAPEC cut oil production, prices had to rise because the American oil industry could not respond by increasing supply. Additionally, non-Organization of the Petroleum Exporting Countries (OPEC) oil sources were declining as a percentage of the world oil industry, and OPEC was therefore gaining a larger percentage of the world oil market. These market dynamics, matched with the effect of OPEC nations’ greater participation rights in the industry, allowed OPEC to wield a much larger influence over the price setting mechanism in the oil market since their formation in 1960 (Merrill 2007).

The devaluation of the dollar that was experienced in the early 1970s was also a central factor in the price increases instituted by OAPEC. Since the price of oil was quoted in dollar terms, the falling value of the dollar effectively decreased the revenues that OPEC nations were seeing from their oil. OPEC nations resorted to pricing their oil in terms of gold and not the dollar (Hammes and Willis 2005). Due to the ending of the Bretton Woods agreement, which had pegged gold to a price of $35, the price of gold rose to $455 an ounce by the end of the 1970s. This drastic change in the value of the dollar is an undeniably important factor in the oil price increases of the 1970s.

...Economists have since come to understand that a central bank can influence the extent to which supply shocks affect inflation, but they face a trade-off. Higher oil prices, because of the widespread effect they have on commodities throughout the economy, will tend to generate both inflationary pressures and slower growth. In the short run, these forces tend to have an inverse relationship, meaning when one rises, the other falls and vice versa. Ben Bernanke for example, discussed this in 2004: “How then should monetary policy react? Unfortunately, monetary policy cannot offset the recessionary and inflationary effects of increased oil prices at the same time. If the central bank lowers interest rates in an effort to stimulate growth, it risks adding to inflationary pressure; but if it raises enough to choke off the inflationary effect…it may exacerbate the slowdown in economic growth.” He goes on to explain that the decision to tighten or ease monetary policy ultimately depends on how policymakers balance the risks inherent in pursuing employment and price stability objectives (Bernanke 2004).

Rising oil prices are deflationary and recessionary when the central bank chooses inflation fighting over economic support. What is the Fed choosing here in the summer of 2022?

New York Fed (PDF): Monthly Review, August 1973, Business Situation.

Alternate Fraser link, doesn't open a PDF

The expansion in economic activity has slowed in recent months, but inflationary pressures have remained extremely severe. In view of the persistent buildup in the backlog of unfilled orders, continued pressures on capacity, and rather widespread shortages of materials and skilled labor, much of the slackening in real growth probably reflects supply limitations. While consumer spending for durable goods and new housing moderated in the second quarter from the very high levels experienced earlier this year and in 1972, it is not possible at this time to determine whether a significant easing of consumer demand is under way. In any event, the price freeze may be temporarily boosting consumer expenditures, and further gains in business inventory and capital spending seem likely in the months ahead. During July the unemployment rate dipped to 4.7 percent, the lowest in more than three years, but both employment and the labor force were essentially unchanged from their June levels.

Price behavior remains a source of very serious concern. Over the first half of the year, both the implicit price deflator for gross national product (GNP) and the consumer and wholesale price measures climbed at the fastest rates in more than twenty years. While some improvement in the statistics as a result of the price freeze has already materialized, demand pressures remain excessive. The Phase Four controls program should serve to spread out the rise in prices as the freeze is ended, but inflation will remain a serious problem so long as aggregate demand continues overly strong.

...After skyrocketing over the first six months of the year, wholesale prices in July fell at a 17 percent annual rate, the steepest drop in twenty-five years. The first decline in the wholesale index in almost two years reflected a sharp plunge in the prices of farm products and processed foods and feeds. In turn, a drop in the price of soybeans, which have been subject to export controls, accounted for much of the decline in the agricultural commodities component. However, since the survey of wholesale prices was taken, the prices of many farm goods have climbed again, so that the improvement in the index is likely to be short-lived. The price freeze apparently has had some success in holding wholesale prices of industrial commodities steady; industrial prices rose at just a 0.7 percent annual rate in July.

I suspect oil could be the culprit this July...