The Oil Embargo and the Unraveling

By December 1972, the Consumer Price Index was rising at 3.4% per year. Nixon had won re-election in a landslide. The economy was growing. Unemployment was falling. The price controls imposed in August 1971 appeared to have worked. The Great Inflation, it seemed, had been tamed by executive decree.

It hadn't. The controls had created shortages, distorted markets, and suppressed prices that were straining to catch up with the underlying monetary expansion. When the Phase III controls were relaxed in January 1973, and Phase IV began its messy unwind over the summer, the suppressed inflation came roaring back. CPI crossed 6% by June, 8% by October, and was still accelerating when the OPEC embargo hit.

What happened next turned an inflation problem into a national crisis. By November 1974, consumer prices were rising at 12.2% per year — the fastest rate since the immediate aftermath of World War II. Gasoline prices had nearly doubled. Unemployment was surging toward 9%. And the Federal Reserve, trapped between fighting inflation and preventing a depression, found that its tools could not solve both problems at once.

Nixon's price controls had always been a political instrument, not an economic one. Phase I (August–November 1971) froze all wages and prices for 90 days. Phase II imposed mandatory guidelines through January 1973. These phases were popular — they made inflation disappear from the CPI printout while doing nothing about the excess money that had been created to finance Vietnam and the Great Society.

When Phase III arrived in January 1973, it replaced mandatory controls with "voluntary" guidelines. Businesses understood the signal. Prices that had been held below market-clearing levels for eighteen months began adjusting. Food prices, which had been under particular strain, surged first. The CPI jumped from 3.6% in January to 6.0% by June — almost doubling in six months.

The producer price index told an even more alarming story. The PPI for all commodities, which captures raw material and wholesale prices before they reach consumers, was running at 14.6% year-over-year by June 1973 — signaling that the worst was still in the pipeline. Commodity markets were repricing everything that the controls had suppressed, and the pressure was building toward the consumer level.

The Fed, belatedly recognizing the problem, began an aggressive tightening campaign. The Federal Funds rate rose from 5.33% in December 1972 to 10.40% in July 1973. It was the sharpest tightening cycle since the postwar era. But the inflation was no longer just monetary — it was about to collide with something the Fed couldn't control at all.

On October 6, 1973, Egypt and Syria launched a surprise attack on Israel — the Yom Kippur War. Ten days later, the Arab members of OPEC announced an oil embargo against the United States and other nations supporting Israel. On October 17, they cut production by 5% and announced they would continue cutting by 5% each month until their political demands were met.

The effect on oil prices was instantaneous and staggering. The posted price of Saudi Arabian light crude, which had been $2.59 per barrel in January 1973, was raised to $5.12 in October, then to $11.65 in January 1974. In the space of twelve months, the price of the world's most important commodity had quadrupled.

For American consumers, the impact arrived at the gas pump. The BLS gasoline component of the CPI tells the story with brutal clarity.

The gasoline CPI index stood at 29.2 in January 1973. By March 1974, it had reached 41.9 — a 43.5% increase in fourteen months. Americans who had paid 36 cents per gallon in early 1973 were paying well over 50 cents by early 1974. But the price increase was only part of the story. Across the country, gas stations ran dry. Cars queued for blocks. Some stations adopted odd-even rationing based on license plate numbers. The Interstate Highway System, which had symbolized American freedom and abundance for a generation, became a stage for national humiliation.

The embargo was officially lifted on March 18, 1974, but the price increases were permanent. OPEC had discovered that it could set prices rather than accept them, and the era of cheap energy was over. The gasoline CPI never returned to its pre-embargo level.

Arthur Burns, the Fed chairman, faced a dilemma that had no clean solution. Inflation was running above 10% and accelerating. Classical monetary theory demanded higher interest rates. But the economy was already sliding into recession — industrial production had peaked in November 1973 and was declining, and unemployment was rising from its 4.6% low in October 1973.

Burns chose to fight inflation. The Fed Funds rate, already elevated from the mid-1973 tightening, was pushed to extraordinary levels. It reached 11.31% in May 1974, 11.93% in June, and peaked at 12.92% in July 1974 — the highest rate in Federal Reserve history up to that point.

The economy broke. Industrial production, which had been at 45.8 in October 1973, began a descent that would take it to 40.0 by March 1975 — a decline of 12.7%. It was the steepest industrial contraction since the Great Depression. Unemployment climbed relentlessly: 5.1% in January 1974, 6.0% in October, 7.2% in December, and eventually 9.0% in May 1975.

And yet inflation barely flinched. The CPI printed above 10% for every single month from February through December 1974. The peak came in November at 12.2%. The Fed was simultaneously presiding over the worst recession since the 1930s and the worst inflation since the 1940s.

By early 1975, Burns relented. The Fed Funds rate was slashed from 8.53% in December 1974 to 5.22% by May 1975. It was an emergency easing into the teeth of ongoing inflation — the kind of move that would have been unthinkable a year earlier but had become unavoidable as the economy hemorrhaged jobs.

The numbers from early 1975 are difficult to read without wincing. In January, unemployment jumped to 8.1% — up a full percentage point in a single month. By May, it reached 9.0%, a level not seen since 1941. Over two million jobs vanished in six months. The auto industry, heavily dependent on gasoline-guzzling models that consumers could no longer afford, was devastated. Real GDP fell 4.7% from peak to trough.

Inflation did come down — but slowly, grudgingly, and not nearly enough. From its 12.2% peak in November 1974, CPI drifted to 7.1% by December 1975. It had taken the worst recession in forty years to bring inflation down by five percentage points. And at 7.1%, it was still nearly double the level that had alarmed policymakers in 1969.

This was the fundamental lesson of 1973-75: once inflation becomes embedded in expectations, it becomes extraordinarily expensive to remove. The economy paid with nine percent unemployment and a 13% decline in industrial output, and inflation was still above 7% at the end of it. The Phillips Curve tradeoff — the idea that you could buy lower inflation with higher unemployment — suggested the cost should have been manageable. Instead, the cost was catastrophic and the result was incomplete.

Supply shocks are more dangerous when they hit an already-inflated economy. The OPEC embargo was an external event beyond American control. But its impact was amplified enormously by the fact that inflation was already running at 8% when the embargo struck. A supply shock hitting a 2% inflation economy is painful but manageable. The same shock hitting an 8% economy produces a 12% emergency. The initial conditions matter more than the shock itself.

Price controls create a false calm before a real storm. Nixon's controls suppressed CPI readings for eighteen months. When they came off, the suppressed prices surged, landing just in time to compound with the oil shock. The controls didn't reduce inflation — they delayed it and concentrated its arrival into the worst possible moment. Every subsequent proposal for price controls has been met with the memory of 1973.

The cost of reducing embedded inflation is vastly higher than preventing it. The 1973-75 recession — 9% unemployment, a 13% drop in industrial production, millions of jobs lost — succeeded in reducing CPI from 12.2% to 7.1%. Five percentage points purchased at an enormous human cost. And 7.1% was still not acceptable. The economy would have to go through this process again, even more painfully, before inflation was finally defeated in the early 1980s. That story — Volcker's War — begins in Episode 6.