If we’ve seen the worst of the oil price shock from the Israel-Iran conflict, then another ostensible impediment to Federal Reserve interest rate cuts may have just disappeared.
Oil prices plummeted on Monday as Iran’s response to US strikes on its nuclear facilities proved much more restrained than the worst-case scenario: A closure of the Strait of Hormuz. Though Iran shot missiles at the largest US air base in the Middle East, they were all intercepted without casualties. President Donald Trump announced that the strikes had been telegraphed and that Israel and Iran had agreed to a tentative ceasefire in their conflict. Provided it holds, the signal from energy markets should allow policymakers to cut rates by September.
Of course, you could argue that oil doesn’t really matter very much for monetary policy — and you wouldn’t be wrong. The contemporary economic orthodoxy is that the Fed should look through temporary supply shocks. In an economy with generally low and anchored inflation expectations, economists expect one-time price level changes to come and go without a lasting impact on inflation trends, and responding with higher interest rates could lead to pointless damage to the economy and labor market. In fact, while oil price shocks are historically associated with recessions, a famous paper co-written by former Fed Chair Ben Bernanke found that “an important part of the effect” comes from ill-advised rate hikes rather than higher oil prices themselves.
But the recent inflationary episode of the pandemic prompted economists to rethink — and possibly overthink — this central question in monetary policy. In a paper presented to policymakers and economics luminaries at a Fed conference last month, researchers Olivier Coibion and Yuriy Gorodnichenko focused on consumer surveys about inflation perceptions and made the argument that inflation expectations were currently and historically unanchored. The paper argued, in a sense, that everything we thought we knew about the Fed and inflation expectations was wrong.
In this case, unanchored means that expectations may be low when inflation is generally low (as in the 2010s) and high whenever realized inflation is high (as in the 2021-2024 period). Consumers and businesses don’t have much core faith in their central bank, and their expectations go wherever the wind blows. Since inflation is a self-fulfilling prophecy, unanchored expectations create the conditions for one-off shocks to turn into sustained periods of inflation. The implication of the Coibion-Gorodnichenko paper was that the central bank should reverse the earlier rule of thumb and take action in response to any oil supply shock, using its tools to bring inflation back to target as quickly as possible.
