In the post-World War II period, until the beginning of the 1970s, oil price fluctuations were very small. From 1949 to 1970, average annual fluctuations of oil prices in U.S. dollars, as measured by the absolute value of year-to-year price changes, were of the order of 1%. Therefore, the real price (i.e., inflation adjusted) slightly declined throughout this period. This so-called Golden Age peak oil impacts period was characterized by a remarkable price stability and very strong gross domestic product (GDP) growth in the main industrialized economies. The stability of oil prices was an important element behind the low inflation and strong economic growth.
In the 1970s, the price of oil increased dramatically as a result of the deliberate action of the Organization of Petroleum Exporting Countries (OPEC), by controlling the quantity oil and energy supply to the world market. In 1974, the oil price reached $11.50 per barrel, more than triple the price from the previous year and almost five times above the 1972 price (unless otherwise specified, the prices given herein are U.S. dollars). Some years later, in 1980 and 1981, oil prices reached values above $30 per barrel, duplicating levels achieved in the previous years.
The direct link between oil prices and inflation is illustrated by examining inflation rates; in Organization for Economic Cooperation and Development (OECD) countries, inflation reached maximum levels of about 15% in 1974 and 13% in 1980, as a result of rising oil prices. It is now widely accepted that monetary policy did not deal adequately with the first oil price shock in 1973, contributing to a situation that led to the so-called Great Inflation period. Indeed, ambivalent monetary policy, conflicted over price stability and short-term growth objectives, failed to provide an anchor to inflation expectations. It is also worth mentioning additional circumstances that were threatening price stability at the time: latent inflation pressures had emerged in OECD countries at the beginning of the 1970s, reflecting capacity constraints; powerful trade unions and the overall acceptance of wage indexation favored the existence of second-round effects; and the Bretton Woods institutional framework collapsed and floating exchange rates were adopted.
The rise in worldwide inflation after the oil price increase of 1979–1981 was much more short-lived than the one in the mid-1970s. The reaction of monetary policy to the oil price shock was clearly different, mainly orientated toward the objective of maintaining price stability. In this context, it is worth mentioning that a new strategic framework for monetary policy was adopted in some countries; the intermediate monetary targeting adopted by the Bundesbank deserves special reference.
In the first half of the 1980s, the oil cartel was not able to enforce the production quotas set for its members. The supply of oil increased when some countries produced more than their quotas and new producers entered the market, and oil prices started to decline. The price collapse of 1986, following serious disagreements within OPEC, marked a turning point from the previous upward trend in oil prices. Oil prices started to fluctuate within a narrower band, while inflation recorded a noticeable downward trend from double-digit figures to figures close to 2%. However, oil price volatility remained a central feature of the world oil market. Oil prices decreased to around $10 per barrel in late 1998 and early 1999. After seriously misjudging the oil market during that period and even contributing to the collapse of prices, OPEC successfully pushed prices upward, overshooting its goal, and prices recovered vigorously, reaching slightly more than $30 per barrel in 2000. In 2003, oil prices were affected by the war in Iraq, remaining close to $30 per barrel in the first half of the year.
Despite all of these fluctuations in oil prices, inflation remained close to 2–3% in the main advanced economies, at least from the second half of the 1990s onward. Within the main advanced economies, the sensitivity to oil price inflation and fluctuations has declined over the past two decades. Moreover, during this period, an increase in the credibility of monetary policy decisively diminished the size of the second-round effects associated with oil price fluctuations. Central banks clearly signaled that they were focused on future inflation, rather than on current inflation, and therefore were not reacting to changes in headline-driven inflation created by transitory factors, unless if these were likely to induce changes in inflation expectations.
