What an Oil Shock Means for Monetary Policy

It’s still very early days in assessing the impact of the war in Iran on the global economy and on financial markets. There’s a lot more that we don’t know than there is that we do know. But it is far enough along for us to say that there will be an impact.

The transmission mechanism between that conflict and the global economy is likely to be through oil prices. While the move in oil prices has been large this time, it isn’t unprecedented. Certainly, we have seen bigger moves in energy prices as recently as the initial stages of the Russian invasion of Ukraine.

A good rule of thumb is that for every 10% increase in the price of oil in the US, that feeds through to headline inflation to the tune of about 0.2 percentage points. That’s meaningful, for sure, but it isn’t a paradigm shift.

It’s important to remember in that context, though, that it isn’t only inflation that is subject to change as a result of energy prices. Rising gasoline prices are essentially a tax on households and a tax on businesses, and the net result usually is slower growth. You have businesses and households having to spend more on fuel and less on more productive goods and services, and that slows the economy.

That combination of higher prices and lower growth is why we often talk about energy price shocks as being stagflationary. It’s not clear what the policy response to a stagflationary shock is supposed to be.

To the extent that central banks respond to higher prices, they would respond with tighter policy. This is the history in Europe, for example, where the European Central Bank has a single mandate to fight inflation and tends to raise rates in the face of supply shocks like this one. Certainly, the markets are pricing a significant probability that the ECB does raise rates over the next few months.

But the Fed has a dual mandate where they are required to focus not only on inflation but also on growth and on the labor market. And as the conflict drags on, if it does, the impact on growth is likely to get greater, and that puts the Fed in a difficult spot. If they’re going to respond to inflation, they should be tighter. If they’re going to respond to slower growth, they should be easier. And to us, that’s a recipe for policy stasis in the near term and probably even in the medium term. We think the Fed is likely to wait and see whether the inflationary impact or the growth impact is greater.

From a financial market perspective, stagflationary shocks like an oil supply disruption are difficult to manage. It’s not clear if markets should respond more to the potentially inflationary aspect of it or more to the growth slowdown aspect of it.

In the near term, what that has led to more than anything else is volatility. We’ve seen interest rates go up. We’ve seen equity markets go down. We think some of those moves are overdone at this point. The market is pricing a greater probability of a rate hike than we believe is likely, and indeed, our forecasts still have the Fed cutting rates over the course of the next 18 months or so.