(Yahoo! Finance) - The Federal Reserve's response to the biggest spike in oil prices since the 1970s hinges on how long the energy shock lasts, Fed Chair Jerome Powell said last week. Right now, officials are watching to see what happens.
“It'll come down to how long the current situation lasts, and then what are the effects on prices, and then how do consumers react,” Fed Chair Powell told reporters last week. “The economic effects could be bigger. They could be smaller. They could be much smaller or much bigger. We just don't know.”
Conventional wisdom holds that, historically, the Federal Reserve has not responded directly to oil price spikes.
Chair Powell said last week that the “standard learning” for the Fed has been to look through energy shocks. However, that has been dependent on inflation expectations remaining well anchored. Consequently, the Fed's response should be taken in the context of inflation remaining above the Fed’s 2% goal for the past five years.
“We have to keep all of those things in mind,” Powell said, adding that the Fed won't approach the question of whether to look through energy inflation lightly.
What the Fed's history says about previous oil shocks
A look at how the Fed has reacted to oil price spikes over the past 50 years shows that the central bank tends to focus on inflation when its credibility is at stake, according to research led by Matthew Luzzetti, chief US economist at Deutsche Bank Securities.
Yet there were episodes in which the Fed initially focused on the impact of high energy costs on growth rather than inflation, suggesting that the economic backdrop at the time of the oil shock matters.
In 1973 and 1974, crude oil prices quadrupled from around $3 a barrel to nearly $12 per barrel during the Yom Kippur War and Arab oil embargo. The Fed chair at the time, Arthur Burns, and the majority of the central bank believed raising rates would worsen rising unemployment, so the central bank focused first on the impact of energy inflation on growth.
Before the energy crisis, the Fed had been raising rates to combat inflation in the first half of 1973 but shifted its focus later that year as the economy weakened. As inflation picked up, Burns and the Fed switched back to aggressive hikes by mid-1974.
During the 1979 Iranian revolution, crude prices more than doubled from $14 to over $35 by early 1981. Under then-Chair Paul Volcker, the Fed aggressively fought inflation. Volcker prioritized tackling inflation, even at the cost of a recession, and the Fed raised the rates to a peak of 20% in 1980.
From 1990 to 1991, during the first Gulf War, crude oil prices nearly doubled. Again, the central bank focused on inflation, then shifted its focus to growth. Alan Greenspan, then the Fed chair, had already begun raising rates to counter rising inflation before the invasion began, and the Fed opted to hold rates steady to contain inflation pressures. The Fed did not lower rates until late 1990, when a mild recession began.
The most recent event was four years ago, when Russia invaded Ukraine and oil prices jumped above $100 per barrel, reaching $120 in early March 2022. Fed Chair Powell said the central bank would proceed with rate hikes. The Fed embarked on its most ambitious rate-hiking cycle since the 1980s in March 2022, though the sole driver was not rising oil prices but inflation that had risen post-pandemic.
Two scenarios for the war in Iran
Fed Governor Chris Waller said that he considered cutting rates last week following the soft February jobs report but that he was inclined to hold rates steady because the war in Iran looked like it could be much more protracted, keeping oil prices higher for longer.
“If it's at a very high level and it stays high for months on end, then at some point it bleeds through because oil is an input into so many products,” Waller told CNBC. “That's where you worry about high and persistent oil shocks. It's not like a transitory goes up and it comes right back down.”
Waller noted that the energy crisis in the 1970s wasn't a one-time oil shock but a sequence of shocks that began to look permanent rather than temporary. After responding to the growth concerns stemming from the oil shock in the '70s, Fed officials realized that this might have been a mistake, and that became central bank wisdom from the '80s onward.
“If the oil goes up and then it comes down, it's very different than if oil goes up and then stays there for a long time,” Waller said.
“That's where you get back to this issue when it bleeds through back into the core inflation, then you do have to respond,” he continued. “That's one of the critical things that I started thinking about — [that] this inflation problem may be worse than I think it is if this continues.”
Meanwhile, San Francisco Fed President Mary Daly noted on Monday that policy is in a good place and that she sees two possible paths for the economy amid the Iran war.
In one scenario, the conflict in the Middle East resolves quickly, energy prices fall, and the impact on the US economy is short-lived and muted. Daly said that under those circumstances, it likely would make sense to look through the temporary rise in energy prices.
But if the conflict becomes prolonged, Daily said the disruptions in energy supply and associated cost pressures could persist, with increased risks of higher inflation, slower growth, and a weaker labor market.
“This would amplify the current tradeoffs for monetary policy, making it harder to balance the risks to both sides of our dual mandate,” Daly wrote in a post on LinkedIn.
Deutsche Bank's Luzzetti posited that the Fed will remain on hold for the time being. He thinks the market could give the Fed some leeway to “look through” another supply-side shock.
Still, he noted that inflation has been too high for too long, and the latest data casts doubt on how much disinflation can reasonably be expected. On the flip side, he said that while growth looks strong, there are risks ahead.
If oil were sustained at $100 per barrel, Deutsche Bank finds the projected tax benefits to consumers from the One Big Beautiful Bill Act would still exceed the drag from the implied “energy tax” increase. However, at $150 per barrel, the increase in energy costs would present a more serious threat to the outlook for consumer spending.
If oil were to hold at $100 per barrel or more over the next quarter, it would enter a “danger zone,” hurting growth.
On Monday, President Trump announced that the US is engaged in talks with Iran and that there were 15 points of agreement to potentially end the war. The president was hopeful that the Strait of Hormuz — the critical chokepoint that has driven oil prices higher — would reopen soon.
When asked who would control the strait, Trump said, “Maybe me,” as well as the Iranian leader at the end of the war.
The president predicted that the price of oil, which has surged 50% since the war broke out on Feb. 28, would drop like a rock when the strait opens.
Last Wednesday, after the Fed opted to hold rates steady, Chair Powell said that increased short-term inflation expectations reflected impacts from the war in the Middle East as well as tariffs slowly working their way through the economy.
Powell noted that officials expect higher energy prices to push up overall inflation in the near term.
“The possibility that our next move might be an increase did come up at the meeting, as it did at the last meeting,” he said. “The vast majority of participants don't see that as their base case, and of course, we don't take things off the table.”
By Jennifer Schonberger - Senior Reporter
