1973 or 1995? Two Scenarios for Oil Prices as Interest Rate Hikes Wind Down

As this round of interest rate hikes comes to an end, the United States has reached a crossroads again. Should it fall into the great stagflation similar to those after 1973, or continue the information revolution as it did after 1995, with its opponents falling into recession one by one? Crude oil has once again become an important influencing factor. By comparing historical experiences, it can be found that the risk of a repeat of 1973 is greater, while the margin for error in replicating 1995 is very low.

As the Fed's interest rate hike cycle comes to an end, the market has begun to focus on the picture of subsequent interest rate cuts. The debate over a "hard landing," "soft landing," or even "no landing" occurs daily. Among the most popular are the arguments concerning the classic interest rate reduction scripts of 1973 and 1995.

In the 1970s, the Federal Reserve experienced a process of rapidly cutting interest rates after an initial phase of rate hikes. The initial interest rate hike in 1973 was actually a remedy for the overheating of the economy caused by the Fed's inaction during the election year of 1972. The personal relationship between Nixon and Fed Chairman Burns led to speculation about whether the Fed was slow to respond to an overheating economy due to its desire to serve the electoral cycle.

The Federal Reserve began raising interest rates only after the end of the election. By August 1973, the Federal Reserve had raised interest rates from 5.5% to 11%.

However, considering that the core CPI has declined to 3.2% for several consecutive months, and the U.S. GDP has shown signs of recession in the third quarter, with the real GDP annualized rate falling to -2.1% quarter-on-quarter, the Fed cut the interest rate in September. This was followed by the infamous secondary inflation surge, with the CPI running at double-digit rates throughout 1974 and leading to a global economic downturn in 1975.

It's not entirely fair to blame the Federal Reserve for the missteps. The runaway rise in crude oil in the Middle East played a key role in the failed rate cut. The strategic competition between the United States and the Soviet Union over the Egypt-Saudi alliance is key to influencing crude oil supply. Egypt had a long-standing cooperation with the Soviet Union in areas such as weaponry and industry. After the Third Middle East War, also known as the Six-Day War, Israel occupied the Sinai Peninsula and refused to return it, causing tensions between Egypt and Israel to escalate.

On October 6, 1973, Egypt launched a surprise attack on Israel, sparking the famous Yom Kippur War, the fourth major Arab-Israeli war. Though Israel emerged victorious with the robust support of the United States and averted a national crisis, a more profound consequence was the subsequent oil shock. At this time, the Federal Reserve had just begun to lower interest rates. Following the outbreak of war, Arab countries initiated oil production cuts and imposed an embargo against the US. The oil shock drove prices from below $3 per barrel to over $10 by 1974. The energy component of the CPI also rose to over 30%, making a crucial contribution to the significant inflation rebound in 1974.

The interest rate cycle started by the Federal Reserve in 1994 has always been regarded as a representative of a perfect soft landing. Greenspan started to raise interest rates when the economy was not overheated yet and the CPI was only 2.5%. After raising interest rates seven times in a year and a half, the interest rate has increased from 3% to 6%, while the CPI almost remained at a moderate level of around 2.5%. In July 1995, the Federal Reserve preemptively cut interest rates before the economy had entered a recession, which contributed to a prolonged period of prosperity in the U.S. economy throughout the 1990s.

The soft landing in 1995 is related to the perfect general environment. The global geopolitical landscape tends toward peace. The World Trade Organization was beginning to take shape, and the internet revolution was in its early stages. Moreover, proactive monetary policy was proven to be more effective at preventing major economic fluctuations.

In the 1990s, there was no longer a US-Russian competition in the Middle East, but it simply transformed into the US dual containment policy against Iran and Iraq. Saudi Arabia and other countries basically maintain a relatively loose supply of crude oil, and the growth of Venezuelan crude oil also makes it in an overall abundant state during this period.

The oil price before the interest rate cut in 1995 mainly depended on macroeconomics. Events such as the collapse of Barings Bank showed that there were signs of financial risks at that time. Crude oil fell from about US$19 per barrel to US$16 in the second quarter before the interest rate cut. However, after the interest rate cut was implemented, the U.S. economy quickly improved, and oil prices immediately began to rise, reaching US$23/barrel at the end of 1996. The relatively low price of crude oil also formed the basis for the successful soft landing during this period, with oil prices more often following the broader macroeconomic trends.

In 1973, interest rates were relaxed prematurely while the economy was still overheating, whereas in 1995, rates were cut during a phase of a mild recession. Only a sustained decline in real wages can lead to a drop in demand. Before the rate cuts in 1973, real wages had actually been positive for a long time, and high interest rates did not effectively contain the growth of total demand. This is also highly related to the guiding economic ideology of the American elite. In the 1970s, Keynesian progressivism was dominant in the United States, unions were strong, and the growth in prices would be rapidly reflected in wage increases. In contrast, the guiding ideology in the 1990s was neoliberalism, with factories massively seeking overseas labor, hence a wage-inflation spiral was less likely to occur. Returning to the present, with Biden picking up the mantle of big government and unions, the situation of real wages in the United States more closely resembles the script from the 1970s.

The second important factor is the geopolitical competition. Although the Saudi-Egyptian leaders pay more attention to secular and geopolitical interests and often tend to move closer to the United States, such tendencies will only turn into cooperation on oil production policies without interference from Russia and Israel. After the Gulf War and the disintegration of the Soviet Union in the 1990s, not only Saudi Arabia became pro-American, but Russia itself was also pro-American. It became possible for the crude oil supply to remain abundant. Back to the present, Russia has re-established its huge influence in the Middle East after the Syrian War, and the Palestinian-Israeli conflict has also been rekindled. The United States seems to have returned to the situation where Kissinger was tired of shuttling back and forth, but it was difficult to win over Middle East allies to cooperate with it.

Looking at past events, we can see a higher likelihood of facing a situation similar to 1973, whereas there is a much smaller window for making mistakes akin to those of 1995.

In terms of economic guiding ideology, the United States has returned to the big government and labor union model, resulting in real wage growth more like 1973, which means that the economy is more likely to move towards secondary inflation after premature interest rate cuts. In an election year, whether a political interest rate cut similar to Nixon's in 1972 will be replicated is also a core issue that the market is paying attention to.

Geographically, after the Russo-Ukrainian War, Russia's influence may have weakened compared to before, and the attitude of the upper echelons of Arab countries towards Israel has also softened greatly. However, compared with the 1990s, the influence of the United States in the Middle East has also declined significantly. The Biden administration is trying to replicate Kissinger's shuttle diplomacy in the Middle East to resolve the Palestinian-Israeli conflict and reunite Saudi Arabia. It did not do so quickly in the 1970s, and it is still difficult today. Although there will not be an impact like an oil embargo, it will be difficult to reproduce the low-price and sufficient supply of the 1990s.

To sum up, if the Fed cut rates too early, the U.S. economy is more likely to move toward the 1973 script of secondary inflation rather than the 1995 soft landing script. Crude oil is prone to an upward trend in both cases.

Considering that the United States has learned from past experience, the Fed may remain patient before cutting interest rates for the first time, trying to resolve the Middle East issue or waiting for a drop in oil prices caused by overseas risks. If the Palestinian-Israeli armistice, the Abraham Accord, the Saudi-US security agreement are quickly reached, or a financial risk event occurs, oil prices will fall and create conditions for interest rate cuts. After the interest rate cut, crude oil is more likely to have an upward trend.