New research from the Federal Reserve Bank of Boston suggests a fundamental shift in the U.S. energy landscape has altered how oil price shocks impact the domestic economy and, consequently, the logic of monetary policy.
Thanks to improvements in energy efficiency and the expansion of domestic crude oil production, rising oil prices no longer devastate overall employment as they once did. The oil and gas sector tends to expand and hire, effectively offsetting job losses in other industries, leading to significantly greater resilience in the overall labor market.
However, this structural advantage introduces a new challenge. In the past, the wave of unemployment triggered by an oil price shock would help cool demand and passively suppress inflation. This buffer mechanism is now largely ineffective, meaning inflation driven by geopolitical oil price spikes has become more persistent and harder to subdue.
The report emphasizes that the U.S. is not completely immune to oil price risks, but the nature of the shock has been rewritten. The Federal Reserve no longer needs to fear that energy price hikes will cause mass unemployment, allowing policy focus to shift squarely to tackling inflation.
The report notes that compared to the two oil crises of the 1970s, the current oil price shock stemming from tensions with Iran has limited destructive power, making a repeat of the stagflation scenario of high inflation coupled with high unemployment highly unlikely. This provides the Fed with greater policy flexibility.
This research from the Boston Fed comes as Fed officials are working to determine the future course of monetary policy. Markets widely expect the Fed to keep the benchmark interest rate unchanged at 3.50%-3.75% at its June meeting, with the core internal debate being whether action is needed to counter the current geopolitically-driven imported inflation.
The current dominant view within the Fed is to hold steady in the short term and monitor the conflict's subsequent effects. However, officials generally worry that prolonged hostilities could entrench high inflation, and voices have emerged suggesting the possibility of a rate hike later this year.
The Boston Fed's research provides support for this view, suggesting that even if rates are raised, the optimized economic structure means it would not cause the severe employment downturns seen in the past.
In contrast, Morgan Stanley holds a starkly different view, arguing that the current oil price increase is a short-term supply-side disruption and will not be a core reason for the Fed to hike interest rates.
The firm points out that the root causes of current high U.S. inflation are domestic factors such as loose fiscal policy, credit expansion, and massive AI-related capital expenditures, rather than external geopolitical shocks.
Morgan Stanley forecasts a gradual easing of inflation in the second half of the year, with a turbulent job market, making it highly likely the Fed will keep rates unchanged for the full year, with potential rate cuts not expected until 2027.
Market expectations have now completely reversed. Before the disruptions in the Strait of Hormuz, markets were pricing in two rate cuts this year. Now, the probability of a rate hike by year-end has risen to two-thirds, with a full repricing underway in Treasury and interest rate markets.
Fed voting member and Dallas Fed President Lorie Logan struck a hawkish tone, stating that while U.S. employment is generally stable, the decline in inflation has been insufficient, creating a necessity to potentially raise rates later this year to stabilize prices.
Kansas City Fed President Jeffrey Schmid stated that the Fed now faces a choice: either remain patient and keep rates stable, or raise rates to curb inflation that has remained above target for years.
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