Investors are misreading how the Federal Reserve is likely to react to heightened oil prices, Bank of America economist Aditya Bhave said in a note published Tuesday morning.
The Iran war has scrambled the Fed’s rate calculus, with most observers suggesting that rising oil prices will push the Fed to be more hawkish. Rising energy costs, if sustained, put upward pressure on headline inflation. As inflation rises, the thinking goes, the Fed will be less likely to cut rates, fearing that it would risk overheating the economy.
Instead, Bhave said, “supply shocks create risks to both sides of the Fed’s dual mandate.” Instead, Bhave wrote, “Context matters. Compared to 2022, the labor market isn’t as hot, inflation isn’t as high, and fiscal support isn’t as large.”
Bhave noted that since the conflict began, the yield on two-year Treasurys — often taken as a read on expectations for the Federal Reserve’s policy rate over roughly the next two years — has largely tracked oil prices.
“This could be a mistake,” Bhave wrote, arguing that a supply shock “fattens the tails” of policy distribution and puts larger risks on both hikes and cuts.
“When Russia invaded Ukraine, the u-rate was below 4%, core PCE inflation was over 5%, payrolls were running at 500k/month and consumers were flush with Covid stimulus cash,” Bhave said. “By contrast, we now have a soft labor market, moderately elevated inflation and more modest fiscal support. This sets us up for a more dovish Fed response if the oil shock is persistent.”
