Because of high oil prices, will the Federal Reserve raise interest rates? Goldman Sachs doesn't believe so.

News from the Wind-追交易 platform, on April 1st, Goldman Sachs economist Manuel Abecasis published a research report stating that although market expectations for Fed rate hikes surged after the US-Iran conflict erupted, the Federal Reserve is unlikely to raise interest rates in reality.

The report emphasizes that if the economy slips into recession, the Fed is very likely to cut rates, and oil price shocks will not prevent its easing actions. The reasoning is based on four main points:

• The current scale and scope of the oil shock are smaller: Compared to the 1970s, current oil price increases are more modest, and dependence on oil in the economy has significantly decreased.
• Different economic starting points make inflation less likely to spread: The labor market is softening, wage growth is below the level consistent with the 2% inflation target. Long-term inflation expectations remain stable, unlike the runaway expectations in the 1970s.
• Monetary policy starting point is already somewhat tight: Since the conflict began, financial conditions have tightened by about 80 basis points, further reducing the need for additional tightening.
• The Fed generally does not react to pure oil shocks: Historical analysis shows that mentions of oil price shocks in Fed officials’ speeches are not significantly correlated with signals of tightening policy, whereas European Central Bank officials show a stronger correlation.

Goldman Sachs’s baseline forecast remains for two rate cuts by 2026, with a probability-weighted interest rate path that is more dovish than market pricing.

The scale and breadth of this oil price shock are far less severe than past crises

Abecasis points out that even under a “severely adverse scenario,” the magnitude of this oil shock is still smaller than that of the 1970s, and its duration is shorter than in 2021-2022.

More importantly, the current U.S. economy’s dependence on oil is significantly lower than in the 1970s. Data shows that the energy intensity of GDP and the share of gasoline in personal consumption expenditures (PCE) have both declined markedly since then.

At the supply chain level, although the Iran conflict could disrupt trade routes in the Middle East and cause some non-oil commodity prices to fluctuate, so far its impact has been clearly narrower than the large-scale supply disruptions and shortages seen in 2021-2022. Of course, as the conflict persists, supply chain outlooks remain uncertain.

From the perspective of inflation transmission pathways, rising oil prices will significantly push up overall inflation, but their impact on core inflation will be relatively limited, and this shock will fade over time because oil prices are not expected to keep rising annually.

Meanwhile, higher oil prices will reduce real disposable income, dampening economic growth and employment. Goldman Sachs forecasts the unemployment rate will rise to 4.6% by 2026; if oil prices rise further, the increase in unemployment will be even larger.

Mainstream economic research has also held that central banks should “ignore” short-term energy price shocks, similar to tariff shocks. Because oil price shocks are temporary and tend to suppress demand, tightening monetary policy would only worsen labor market damage and would be almost useless for controlling inflation.

This is also one of the reasons why the Fed and other major central banks focus more on core inflation rather than headline inflation.

Fundamentals lack “fueling” conditions, making secondary inflation spread unlikely

Goldman Sachs emphasizes that the current macro environment makes the occurrence of large-scale secondary inflation effects extremely unlikely.

Looking back at history, during the severe inflation periods of the 1970s and 2021-2022, a common feature was extremely tight labor markets and accelerating wage growth.

Before the first major oil shock in 1973, this overheating had already persisted for years; expansionary fiscal policies in the 1960s had pushed the economy to the brink of overheating by the 1970s; similarly, the large-scale fiscal stimulus in 2020-2021 played a comparable role.

In contrast, the U.S. labor market is softening now, with wage growth below the level consistent with the 2% inflation target, and medium- to long-term inflation expectations remain well anchored.

By modeling data from G10 countries, Goldman Sachs believes that when the labor market is relatively slack, long-term inflation expectations are anchored, and fiscal policy is less expansionary, the probability that supply shocks will cause persistent core inflation increases is significantly reduced.

Monetary policy starting point is more neutral, with higher thresholds for rate hikes

The current monetary policy starting point is very different from the two major inflation episodes in the past.

Currently, the Federal Reserve’s federal funds rate is 50-75 basis points above the median estimate of the neutral rate in the Summary of Economic Projections (SEP), roughly aligning with standard policy rule recommendations.

In contrast, at the beginning of 2021-2022, the federal funds rate was at zero, well below the neutral rate; similarly, in the 1970s, policy rates were far below the neutral level and the policy rule recommendations.

Additionally, since the conflict erupted, financial conditions have tightened by about 80 basis points, further reducing the need for active tightening.

The Fed has never historically raised rates solely due to oil price shocks

Goldman Sachs’s historical analysis shows that mentions of oil price shocks in Fed officials’ speeches are not significantly correlated with signals of tightening policy, whereas ECB officials show a stronger correlation.

From the scenario analysis of Fed staff reports to the FOMC, in scenarios with rising oil prices, forecasts typically show: an increase in overall inflation, a slight rise in core inflation, a slowdown in economic growth, and an increase in unemployment, but the federal funds rate remains relatively unchanged from baseline forecasts.

Meanwhile, neither FOMC members nor the Fed Chair have systematically increased policy rate forecasts in response to oil price shocks in history.

Furthermore, historical data shows that during recessions preceded by surges in oil prices, the FOMC has typically lowered the policy rate by about 3.5 percentage points. Goldman Sachs has now increased the probability of recession in the next 12 months by 10 percentage points to 30%, and expects the Fed to start cutting rates once a recession occurs.

Overall, Goldman Sachs believes that the current situation is fundamentally different from the “high-risk” environments of the 1970s and 2021-2022.

In terms of supply shocks’ scale and scope, economic fundamentals’ starting point, initial monetary stance, and the Fed’s historical responses, the threshold for rate hikes in this cycle is far higher than what the market is currently pricing in.