By Lina Irawan 
The specter of geopolitical conflict, particularly involving major oil-producing regions like the Middle East, invariably sends tremors through global energy markets. As the hypothetical U.S.-Israeli war against Iran looms, the immediate and predictable consequence has been a dramatic surge in oil prices. This phenomenon, while a cause for immediate concern, has once again prompted a familiar chorus from pundits, journalists, and a significant segment of economists: the assertion that higher oil prices inevitably fuel broader inflation. This narrative, deeply ingrained in public consciousness and frequently recycled during energy shocks, is not only widely accepted but, upon closer scrutiny, fundamentally flawed.
The prevailing wisdom posits a direct causal link: when the cost of crude oil rises, it ripples through the economy, increasing transportation costs, manufacturing expenses, and ultimately, consumer prices across the board. However, this interpretation conflates a shift in relative prices with an increase in the general price level. A surge in oil prices undeniably alters relative prices within an economy, meaning the price of oil and energy-intensive goods increases relative to the prices of other goods and services. Consumers and businesses must allocate a larger portion of their budgets to energy. But this reallocation of spending does not, by itself, cause the overall inflation rate to accelerate. True, sustained inflation—a persistent and pervasive increase in the general price level—can only occur if there is a corresponding increase in the money supply. As the Nobel laureate Milton Friedman famously asserted, "Inflation is always and everywhere a monetary phenomenon."
To understand this crucial distinction, one must grasp the Quantity Theory of Money, which, in its simplest form, states that the total amount of money circulating in an economy (M) multiplied by the number of times that money is spent (velocity, V) equals the nominal value of all goods and services produced (price level, P, multiplied by real output, Q). That is, MV = PQ. If the money supply (M) and its velocity (V) remain relatively stable, then any increase in the price of one commodity, like oil, must be offset by a decrease in the demand, and potentially the price, of other goods and services if real output (Q) is not expanding significantly. Consumers, facing higher energy bills, have less discretionary income for other purchases. Businesses, facing higher input costs for energy, might have to absorb some of these costs or pass them on, but if the overall money supply isn’t growing, they cannot sustainably raise all prices without a corresponding drop in sales volume. Only when the central bank injects more money into the system, leading to a sustained increase in the money supply, does the purchasing power of each unit of currency diminish across the board, resulting in general inflation.
The most frequently cited historical evidence for the "oil causes inflation" narrative comes from the dramatic inflationary episodes of the 1970s and early 1980s in the United States and other industrialized nations. These periods were punctuated by two severe oil crises. The first, in 1973-74, was triggered by the Yom Kippur War, during which Arab oil-producing nations, organized under the Organization of Arab Petroleum Exporting Countries (OAPEC), imposed an oil embargo on countries that supported Israel, most notably the United States. This political maneuver drastically cut global oil supply, sending prices soaring from approximately $3 per barrel to over $12 per barrel in a matter of months – a quadrupling of prices. The second crisis, beginning in 1979, stemmed from the Iranian Revolution, which disrupted Iranian oil exports, and was exacerbated by the subsequent Iran-Iraq War in 1980, further destabilizing global supply. Oil prices doubled again, from roughly $14 per barrel to over $35 per barrel.
The standard narrative, taught in many textbooks and widely propagated, asserts a direct causal link between these colossal oil price surges and the observed double-digit inflation rates that plagued Western economies during those years. The correlation was undeniable: oil prices spiked, and inflation followed. Yet, even with its widespread acceptance and frequent repetition, this narrative, when subjected to rigorous economic analysis, simply doesn’t withstand scrutiny.
While it is true that each oil crisis coincided with a significant acceleration of inflation in many countries, correlation does not imply causation. The critical factor often overlooked is the underlying monetary policy environment that preceded and accompanied these energy shocks. In the United States, for instance, the inflations of 1973-75 and 1979-81 were not caused by the oil price increases, but rather were the predictable consequences of prior, sustained surges in the broad money supply. Economists often measure this broad money supply using M2, which includes all physical currency, checking deposits, savings deposits, money market accounts, and certificates of deposit—essentially, all readily available forms of money in the economy.
The seeds of the first inflationary surge were sown long before the 1973 oil embargo. From July 1971 until June 1973, the U.S. M2 money supply experienced sustained, aggressive growth, averaging an annual rate of 12.5%. To put this in perspective, this rate was roughly double the monetary growth rate consistent with achieving a stable inflation target of around 2% per year, which is generally considered healthy for economic growth. This expansionary monetary policy, largely a result of the Federal Reserve’s accommodative stance under Chairman Arthur Burns, who prioritized full employment and was wary of triggering a recession, created an excess of money chasing a relatively stable supply of goods and services. Unsurprisingly, with the usual time lag of 18-24 months for monetary policy to fully impact prices, annual headline Consumer Price Index (CPI) inflation began its ascent, rising from 3.7% in January 1973 to a peak of 12.3% in December 1974, averaging a staggering 8.6% over those two years. The oil shock merely provided a convenient scapegoat for inflation that was already "baked in the cake" by prior monetary expansion.
A similar pattern emerged leading up to the second oil crisis. Between January 1976 and December 1978, M2 growth in the U.S. averaged 11.2% per year. This continued high rate of monetary expansion, again a reflection of a Federal Reserve grappling with both inflation and unemployment (the "stagflation" dilemma), set the stage for the next inflationary wave. Consequently, the average annual inflation rate, which had temporarily receded, surged once more, jumping from 7.6% in 1978 to 11.3% in 1979, peaking at 13.5% in 1980, and remaining high at 10.3% in 1981. These inflation spikes coincided with the oil crises, but their true genesis lay in the preceding years of robust money supply growth. The oil price increases were, in essence, a symptom of broader economic imbalances and a proximate cause for a shift in relative prices, but not the root cause of the general inflation. It took the decisive, albeit painful, monetary tightening under Federal Reserve Chairman Paul Volcker in the early 1980s—raising interest rates to unprecedented levels—to finally bring the money supply under control and, subsequently, tame inflation.
Japan’s experience during these two oil crises provides a particularly compelling and instructive counter-narrative, demonstrating with remarkable clarity the paramount relationship between money growth and inflation. Unlike the United States, where a failure to control money growth preceded both oil crises, Japan’s authorities learned a critical lesson from their first inflationary ordeal.
The initial conditions for Japan’s monetary expansion were set in August 1971, when President Richard Nixon announced the "Nixon Shock," unilaterally ending the convertibility of the U.S. dollar to gold at a fixed price of $35 per ounce, effectively dismantling the Bretton Woods system. This move led to an abrupt appreciation of numerous foreign currencies, including the Japanese yen, against the U.S. dollar. Fearing that a stronger yen would severely damage their export-led economy, Japanese policymakers embarked on an aggressively easy money policy. They lowered interest rates and allowed the money supply to accelerate dramatically, averaging an astonishing 25.2% per year between June 1971 and June 1973. This explosive growth in the money supply laid the groundwork not only for a surge in asset prices and rapid economic growth but, crucially, for a sharp rise in inflation. Indeed, Japan’s annual inflation rate jumped from 4.9% in 1972 to 11.6% in 1973, and then to a stunning 23.2% in 1974, precisely as the first oil crisis unfolded. The oil price hike was simply added fuel to an already burning monetary fire.
However, after the severe inflationary consequences of the first crisis, Japanese authorities, particularly the Bank of Japan, implemented a radical and disciplined shift in monetary policy. Starting in July 1974, they announced and meticulously pursued a plan to control M2 growth. Over the following decade, the growth rate of M2 gradually and consistently declined. In the critical period leading up to the second oil crisis, from January 1976 to December 1978, M2 growth averaged just 12.8% per year – effectively halving the growth rate experienced before the first oil crisis. This remarkable monetary discipline paid off handsomely when the second oil crisis erupted.
While relative prices for oil and energy still increased in Japan, the overall CPI inflation rate remained remarkably moderate. It rose only mildly from 4.2% per year in 1978 to a peak of 8.2% in 1980, before quickly receding to 4.9% in 1981. This stark contrast with the double-digit inflation experienced by the U.S. and other nations during the second oil shock offers one of the most compelling real-world demonstrations of the principle that changes in the money supply, not changes in commodity prices like oil, are the fundamental drivers of sustained inflation. Japan’s experience underscores that while oil price shocks can cause temporary price adjustments and reallocations of spending, they do not inherently generate economy-wide inflation in the absence of an accommodating monetary policy.
Moving to the current state of affairs, particularly in the U.S., the lessons from history remain acutely relevant. The substantial budget deficits that have become a recurring feature of fiscal policy, whether under the Trump administration or subsequent ones, pose a significant inflationary risk if they are financed through the banking system and money market funds in a way that expands the broad money supply. When the government issues debt to cover its spending, and commercial banks purchase this debt, it increases bank reserves. If the central bank then engages in quantitative easing, buying these bonds from commercial banks, it further increases the monetary base, enabling banks to lend more and thus expand M2. If this process leads to a sustained acceleration in the rate of growth of the money supply, then headline inflation will indeed pick up, regardless of oil price movements.
Conversely, if the rate of growth in broad money is rigorously controlled by the Federal Reserve, then higher spending on oil and gasoline—even in the event of a dramatic surge due to geopolitical conflicts—will necessarily be offset by lower spending on other goods and services. Consumers and businesses, having a fixed amount of money in circulation, must make choices. If they spend more on energy, they spend less on clothing, entertainment, durable goods, or investments. This reallocation of spending, while potentially impacting specific sectors, restrains overall inflation because the total purchasing power in the economy has not increased. The economy adjusts to the higher relative price of oil without a generalized increase in the price level.
In conclusion, while the immediate reaction to soaring oil prices is often an understandable fear of rampant inflation, economic history and theory unequivocally point to a different culprit: the money supply. Oil price shocks are important economic events, capable of causing recessions, reallocating wealth, and altering industry structures. However, their inflationary potential is entirely contingent on the monetary policy response. If central banks maintain a disciplined control over the money supply, ensuring that its growth aligns with the productive capacity of the economy, then even dramatic surges in oil prices will primarily manifest as relative price adjustments, not as the broad, corrosive inflation that erodes purchasing power across the entire economy. The true battle against inflation is waged not in the oil fields, but in the halls of central banks.
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