Fed Likely to Look Through Oil Price Shock

Summary

• The Middle East remains tense and hostilities could easily restart and cause an oil price shock.
• Because the US is a net energy exporter, but oil producers’ spending is limited, an oil price shock would likely see US income increase but US spending decrease, which would improve the external balance.
• Because of a tighter policy mix than in 2022 and strong Fed credibility, an oil price shock would likely see headline but not core inflation increase and long-term inflation expectations remain well-anchored. This would allow the Fed to look through the shock.

Market Implications

• I still expect two-three cuts in 2025 starting in September, against markets expecting 1.9.

Middle East Geopolitical Risks Persist

The weak market footprint of the ‘Twelve days’ war’ is striking. Twelve days after the onset of the war on 13 June, WTI and SPX are $3/barrel and 80bp, respectively, above pre-war levels while 10yr yields and DXY are 7bp and 19bp, respectively, below (Chart 1).

Nevertheless, risks of further conflict remain substantial as betting markets show (Chart 2). Here, I discuss the economic consequences of renewed escalation and an associated oil shock.

Irrespective of whether the ceasefire lasts, the Israel-Iran war is likely to have added to uncertainty and therefore weigh on private sector confidence (Charts 3). The recovery in confidence has been uneven as the most recent consumer and business surveys show (Chart 4).

Soft survey data weaknesses have started transmitting to hard data. The Atlanta Fed Q2 GDP nowcast (almost entirely based on high frequency hard data) is slowing (due to measurement issues in final sales, i.e., GDP ex net exports and inventories is the better indicator of growth, Chart 5). Similarly, the Dallas Fed weekly economic index, a proxy for YoY GDP growth based on high frequency hard data, is also slowing (Chart 6). The growth slowdown is also apparent through labour market and demand indicators (Charts 7 and 8).

With continued peace, the impact of the twelve days’ war would merely delay the recovery in soft and hard data and would not impact the long-term economic outlook. My outlook remains of equal probabilities of self-correcting growth weakness and recession.

However, a resumption of hostilities could cause a full-fledged oil shock.

Chart 1: Weak Market Footprint of Middle East War	Chart 2: Middle East Peace Remains Fragile
Chart 3: Middle East War Adds to Uncertainty	Chart 4: Private Confidence Remains Weak
Chart 5: QoQ GDP Growth Is Slowing	Chart 6: Slower High Frequency Indicators
Chart 7: Employment Growth Is Slowing	Chart 8: Retail Sales Growth Is Slowing

Oil Shock Would Lift Income but Lower Spending

An oil price spike would have to be long lasting to register on a macro scale (Chart 9). For instance, in 2008 WTI prices peaked at $145/barrel but averaged only $90/barrel during the peak month (Table 1). WTI rising to about $120/barrel for a few months could be a price level associated with the closure of the Strait of Hormuz, an unlikely scenario.

The US is a net energy exporter to the tune of 3.5% of GDP, mainly due to LNG exports with oil accounting for about 1ppt (Chart 9). Therefore, an increase in oil prices would raise US income.

However, within the US, sectors that are net buyers of oil (i.e., households and non-oil businesses) would face higher energy costs. The impact on consumption could be substantial. Energy represents about 3.5ppt of total consumption. An increase in oil prices to about $120/barrel would likely see an increase in consumer energy prices of about 35% and a decrease in households’ real income of about 1ppt (energy consumption is inelastic in the short term). This could translate into a GDP decline of about 0.7ppt (consumption represents 70% of GDP).

Against this consumption decline, oil producers could increase investment, but this would be very unlikely to make up for the consumption decrease. First, investment in oil facilities and equipment represents 1.5ppt of GDP at most. Second, in recent years shalers have become more disciplined with capital expenditures and may not expand investment unless convinced the price increase would be long lasting. For instance, in 2022 the number of rigs remained below pre-pandemic levels despite the spike in oil prices (Chart 11).

Overall, an oil shock would likely see US income increase but US spending decrease, which would translate into an improvement in the trade balance and limit the long-term impact on inflation.

Table 1: A Genuine Oil Shock Would Require Long Lasting Spike

in Oil Prices

Chart 9: Middle East Instability Could See Oil Shock	Chart 10: Higher Oil Prices to Lift US Income
Chart 11: Rigs Decoupled From Oil Prices	Chart 12: Core Followed Headline PCE in 2022

Oil Shock Unlikely to Lift Core Inflation

Headline inflation spiked in the 2008 and 2022 oil shocks. However, core inflation remained stable during the former but rose in the latter (Chart 12). The spike in core in 2022 reflected a combination of very loose monetary and fiscal policies as well as labour and goods shortages.

None of these apply this time. Monetary policy is much tighter; there is no fiscal impulse (although the budget deficit remains high), the labour market is softening, and the recently agreed US-China trade deal limits risks of goods shortages (Chart 13).

Similarly, long-term inflation expectations were much better behaved in 2008 than in 2022. In 2008, 5y5y BEs, the Fed’s preferred inflation measure, barely moved despite the spike in oil prices (Chart 14). By contrast in 2022, long-term BEs rose with oil prices and started de-anchoring. This led to the fastest tightening cycle since the early 1980s, with the Fed hiking 425bp in 2022 alone.

This time, because inflation has been above target for the past four years, the Fed has become very focused on the risk of long-term inflation expectations de-anchoring. This is a key driver of its decision to remain on hold through the summer to ascertain risks associated with US tariffs.

Because of the more benign policy environment and the strong Fed response to the 2021-22 inflation spike, I do not believe expectations would de-anchor. But if that were the case, the Fed would likely end its easing bias.

Overall, based on stable core inflation and long-term inflation expectations, the Fed can likely look through an oil price shock.

Chart 13: Tighter Policies Than in 2022	Chart 14: Low Risk of De-anchoring Inflation Expectations

Market Consequences

The macroeconomic consequences of WTI prices spiking to $120/barrel in a lasting manner would likely lower growth and raise headline but not core inflation. I also expect 5y5y BEs would remain near current levels.

But as Viresh explained, oil at $120/barrel is an unlikely scenario. I still expect the growth slowdown to limit the impact of tariffs. Therefore, I still expect two-three 2025 cuts starting in September in line with markets pricing 90% chance of a cut by September and 2.5 cuts by December.

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