The prevailing view was that central banks weren’t hawkish enough against the first oil price shock in 1973.
When Arab nations cut production in response to the US’s support for Israel during its war with Egypt and Syria, oil prices quadrupled.
But central banks were initially slow to hike up interest rates, fearing the impact on activity and employment.
Firms had already begun to lay off workers in response to the jump in operating costs.
The US Federal Reserve initially reduced interest rates in late-1973, before tightening again into 1974, but then loosening later in 1974 as unemployment rose.
The pattern was mirrored elsewhere. It was a miscalculation.
By 1975, most advanced economies were experiencing the most dreaded of all economic phenomena: stagflation (higher inflation and higher unemployment). Inflation in Ireland reached an all-time high (for the modern era) of 21 per cent.
The central dilemma for central banks then, as it is now, was whether to address the price shock head on with higher interest rates, or hold firm in the hope that it was temporary and would quickly pass through the system.
The European Central Bank (ECB) finds itself in this dilemma right now.
The longer policymakers leave interest rates unchanged in the face of rising prices, the more expectations, a key inflation determinant, become “de-anchored”.
Workers start to demand more wages, firms put up prices in response, a negative feedback loop can form.
The messy response to the 1973 shock prefigured a more hawkish response to the next one.
In 1979, in response to the fall of the shah in Iran and the ensuing cut in oil production, central banks quickly raised rates.
US Federal Reserve chairman Paul Volcker lifted US interest rates to 20 per cent in 1980-1981, crashing the US economy into a deep recession but ultimately taming inflation.
Painted as a villain at the time, Volcker is now recalled as a hero.
[ Tax receipts up €1.1bn despite Iran war price shockOpens in new window ]
“A consistent theme of economic cycles is that policymakers tend to correct (and often overcorrect) for past mistakes,” Deutsche Bank said in a recent research note.
“The lessons of the last crisis are always top of mind.”
It also noted that while central banks slashed interest rates aggressively and adopted quantitative easing programmes in response to the 2008 global financial crisis, the post-crisis recovery was slow and, according to critics, might have benefited from more forceful interventions.
“As the years went on, the perception grew that the recovery had been too sluggish after 2008, and policymakers should have responded more forcefully, particularly given inflation and interest rates were at historically low levels,” it said.
So when the pandemic hit in 2020, central banks took a more hawkish approach. Relatively early on, the ECB announced the Pandemic Emergency Purchase Programme (Pepp), which had a total envelope of €1.85 trillion by December 2020.
On the fiscal front, governments, including the Irish one, effectively nationalised part of the private sector wage bill, successfully cushioning their economies from the blow.
The next chapter of this underreaction, overreaction story comes in 2022.
Inflation started to surge in 2021 but central banks insisted it was a transitory, post-Covid phenomenon that would pass relatively swiftly.
They held this view right up to Russia’s invasion of Ukraine effectively settled the argument.
Inflation was already triple the ECB’s 2 per cent target rate when it finally began lifting interest rates in July 2022.
The upshot of this perceived underreaction is a more hawkish stance now.
ECB president Christine Lagarde has warned the institution would not be “paralysed by hesitation”. At its April meeting last week, she noted that while the final decision to hold rates was unanimous, policymakers discussed “at length” the possibility of a rate hike.
Slovakia’s Peter Kazimir said a rate hike is inevitable. Photograph: Martin Baumann/TASR via AP/PA
Since then, Bundesbank president Joachim Nagel has said a rate hike will be needed if there is no significant improvement in the outlook for inflation, while Slovakia’s central bank governor Peter Kazimir said “it’s all but inevitable”.
“It is becoming increasingly likely that we must prepare for a prolonged period of broad-based price increases coupled with visibly weaker growth across the eurozone,” Kazimir said.
The dilemma for the ECB is in trying to stem the current tide of inflation with higher interest rates, it risks dampening already fragile growth and pushing the bloc into recession.
The eurozone economy barely grew in the first quarter, even before the war had any meaningful impact.
Lagarde has, however, dismissed suggestions the bank is facing a 1970s-style “stagflation” problem principally because employment remains strong.
But the impact of higher energy prices, including the likely secondary effects such as higher food prices, takes time to materialise.
“Today we face the prospect of a fresh inflation surge driven by an energy shock, which bears strong similarities to four years ago,” Deutsche Bank said.
“But given that policymakers underestimated the extent of the 2022 inflationary surge (as they did with the first oil shock of 1973), this makes it far less likely they’ll make that mistake this time round,” it said.