Dario Perkins of TS Lombard wrote a piece titled “How to Respond to Oil Shocks.” His analysis draws on the Fed’s history to address how it should respond to today’s oil shock. While researching Fed transcripts from the 1990 Gulf War, he discovered a proposal by Don Kohn, senior Fed staffer, that offers a solution to the central bank’s oil shock problem: nominal GDP targeting.
Kohn’s logic is straightforward and makes sense in the current environment where the Fed is contemplating monetary policy as oil prices spike, simultaneously boosting inflation and reducing economic growth. Per Kohn, if those two forces balance out, the Fed should hold rates steady.
But if one dominates, the Fed should respond: “hike if nominal GDP growth rises” and “cut if nominal GDP growth falls.” In other words, a demand shock calls for higher rates, while a supply-side shock calls for lower rates. Historically, as he shares in the table below, nominal GDP almost always falls after a supply-driven oil shock. Today’s spike, driven by the Iranian conflict and “the Iranian weaponization of the Strait of Hormuz,” is unambiguously a supply shock. By the Kohn framework, the Fed should be cutting the Fed Funds rate, not considering hiking it.
The current counterargument is the high-inflation era of the 1970s, when central banks were allegedly too dovish on inflation and allowed inflation expectations to spiral out of control. Perkins dismisses this comparison directly. To wit:
The 1973-74 recession “was one of the worst in history” and “in terms of its impact on unemployment, it was only slightly better than the GFC.”
Importantly, he notes that the 1970s featured widespread union membership and inflation-indexed wage contracts that caused wages to “accelerate even as the economy sank.” That wage-price spiral is nonexistent today. Thus, the inflationary danger of easing into an oil shock is considerably lower than the popular 1970s narrative suggests. His conclusion:
Central banks don’t need to hike today. In fact, if they follow the advice of Don Kohn, they will probably need to ease policy.
JOLTS– Employment Update
The data once again confirmed that the labor market is in a low-hire, low-fire environment. The first graph below, courtesy of Ernie Tedeschi, shows that the labor market churn rate is near the worst since 2000. The data also confirm that labor market trends continue to weaken gradually.
The headline figure for the number of job openings is 6.882 million. This is a decrease of 360,000 from the previous month’s 7.240 million. However, it has been rangebound over the past few months. The job openings rate fell from 4.4% to 4.2%. The hiring rate of 3.1% is the lowest since April 2020, when COVID-19 lockdowns shuttered the economy.
Many consider the quit rate a barometer of the labor market. When workers voluntarily leave their jobs, it’s a sign of confidence that they can find better conditions, and it serves as a leading indicator of wage inflation. Conversely, when they stay in their jobs, it reveals a lack of confidence in their ability to find a new, higher-paying job. The quit rate in February was 1.9%.
Higher Oil Prices Impact Consumers
The fear-mongering over whether the Iran conflict will trigger a decade-long 1970s-style inflation wave is all over social media. As we led, the real threat is not prolonged inflation but weaker economic growth. To wit, consider that the average American household spends approximately $3,000 to $4,000 annually on gasoline. At $100 per barrel, that figure rises by $1,200 to $2,700 per household relative to a $ 70-per-barrel baseline.
Then take into account higher utility bills, elevated food prices driven by fertilizer and transportation costs, and the broader pass-through of energy costs into many goods and services consumers buy. Many consumers will be forced to reduce spending on other goods and services such as retail outlets, restaurants, cars, or entertainment venues.
With a mere 0.7% growth in the fourth quarter, the economy and consumer were already showing signs of fatigue before the Iran conflict began. Credit card delinquencies had been rising, savings rates had declined from their post-pandemic highs, and high-income consumer spending (the cohort that drives a disproportionate share of discretionary economic activity) was beginning to soften. As we share below, consumers are saving at rates lower than at any time in the last ten years, except during the volatile 2020-2022 post-pandemic period.
Oil-driven price increases hitting an already stretched consumer are a meaningful headwind for corporate earnings in consumer-facing sectors and the companies that service them. Investors focused on the macro debate over yields and Fed policy may be underestimating the more direct and immediate impact that higher energy costs will have on the American consumer.
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