Historically, oil price spikes represented a significant negative shock to the US economy. Prior to the emergence of shale in the US, the impact was primarily one sided. Higher oil prices drove up energy costs for households and businesses, exerting a clear negative impact on economic output. However, with the emergence of shale energy in the US, the impact of oil price movements on economic activity has become more balanced. Although higher oil prices continue to represent a cost shock for households and most businesses, there is now a more meaningful offset from benefits to energy producers and through the export channel. Due to these offsetting channels, the growth impact of oil price shocks is fairly modest. A $20 oil price shock, similar to that observed recently, would have a small impact on growth. The peak effect is only about a one-tenth drag on the level of output one year ahead. The impact on the unemployment rate is about half. A $60 oil price shock would have larger effects – given the linear nature of the model the impact is three times the $20 oil shock scenario. With oil prices around $120 per barrel, real GDP would be depressed by about 0.2 percentage points over a year and the unemployment rate would rise by a tenth. Unlike real GDP and the unemployment rate, an oil price shock has a significant effect on headline inflation. Conversely, given the muted impact on activity, the pass-through of an energy price shock to core inflation is generally small. A $20 oil price shock initially lifts headline PCE inflation by about 70bps in the quarter of the shock, though the impact dissipates materially with only an 11bps increase for the year following the shock. The $60 oil price shock impact scales by a magnitude of three – initially headline PCE inflation is 2ppt higher, with the impact moderating to 35bps over the year. Simulations show that oil price shocks similar to those outlined above are initially a modest dovish impulse for the Fed. With growth adversely affected and the unemployment rate pushed modestly higher, while core inflation is mostly unaffected, the Fed can focus on the labor side of the dual mandate. That said, the calculus could be somewhat different in the current environment, where supply-side shocks (i.e., tariffs) have already kept inflation well above the Fed’s target. Which bias is correct – the dovish bias implied by the Fed’s model or the market’s belief in a more hawkish impact on Fed policy? The market appears to have agreed with the “wait-and-see” bias from the Fed, with the 2-year Treasury yield rising about 19bps since last Friday – down from a peak rise of nearly 20bps. Consistent with this move, the market removed about 17bps of easing from 2026 and now only anticipates about 44bps of reductions. This is in spite of a super weak Feb Non-Farm Payroll no. Taken together, we think this historical perspective reinforces a Fed on hold for the time being until clear evidence emerges that they should adjust policy. We continue to expect the Fed to cut rates twice this year (in June & Sep) once Kevin Warsh takes over as Fed Chair. We see brent in the range of 80-100 now unless there is an off ramp by either Iran or Trump. We see this off ramp as a low probability event as both parties do not see much losses in current scenario. Iran has already lost it’s supreme leader and seen the worst of aerial attacks. Their missile and drone capabilities are impacted but still enough to create nuisance value for civilian life in middle east. As long as they can ensure this sustained low intensity warfare continues with Strait of Hormuz effectively closed for transits, pressure is on surrounding gulf countries to put pressure on Trump to pull back. But Trump does not see many losses in his calculations as long as US equities are relatively unharmed. Only if S&P500 goes below 6500, Trump might start thinking of off ramps. Till then we can expect the current standoff to continue. This implies further downside to risk assets specially equities. US rates can remain elevated and DXY strong. Precious metals have seen their best days, and we see scope for large fall there in either scenario of a sustained war (stronger DXY leads to lower Gold/Silver prices) or a ceasefire (geopolitical risk premium vanishes leading to fall in Gold/Silver prices).
