Because of high oil prices, will the Fed raise rates? Goldman Sachs doesn't believe so

Follow the wind trading desk news, on April 1st, Goldman Sachs economist Manuel Abecasis published a research report pointing out that although market expectations for a Federal Reserve interest rate hike have sharply increased after the outbreak of the US-Iran conflict, it is actually unlikely for the Federal Reserve to raise interest rates.

The report emphasizes that if the economy falls into recession, the Federal Reserve is highly likely to cut interest rates, and the oil price shock will not prevent its easing actions. This is mainly based on four reasons:

• The scale and scope of the current oil shock are smaller: Compared to the 1970s, the current oil price increase is smaller, and the economy's dependence on oil has significantly decreased.
• Different economic starting point, inflation is difficult to spread: The labor market is softening, and wage growth is already below the level consistent with a 2% inflation target. Long-term inflation expectations are stable, which is different from the situation in the 1970s where expectations spiraled out of control.
• Monetary policy is starting from a tight position: Financial conditions have tightened by about 80 basis points since the conflict began, further reducing the need for additional tightening policies.
• The Federal Reserve typically does not react solely to oil price shocks: Historical analysis shows no significant correlation between oil price shocks mentioned in Federal Reserve officials' speeches and signals of tightening policy. In contrast, European Central Bank officials have shown a strong correlation.

Goldman Sachs' base case forecast remains two rate cuts in 2026, with its probability-weighted interest rate path forecast being more dovish than market pricing.

The Scale and Breadth of the Current Oil Price Shock Are Far Less Than Historical Crises

Manuel Abecasis pointed out that even when calculated using a "severe adverse scenario," the magnitude of the current oil price shock is still less than in the 1970s, and its duration is shorter than in 2021-2022.

More importantly, the current US economy's dependence on oil is significantly lower than in the 1970s. From a data perspective, both energy intensity of GDP and the proportion of gasoline in personal consumption expenditures (PCE) have significantly decreased compared to that period.

At the supply chain level, although the conflict in Iran may disrupt trade routes in the Middle East and affect the prices of some non-oil commodities, its scope of impact so far is narrower than the large-scale supply disruptions and commodity shortages during 2021-2022. Of course, as the conflict continues, the outlook for supply chains remains uncertain.

From the perspective of inflation transmission channels, rising oil prices will significantly push up overall inflation, with a relatively limited impact on core inflation, and this shock will fade over time, as oil prices do not continue to rise year after year.

At the same time, higher oil prices will depress real disposable income, drag down economic growth and employment. Goldman Sachs expects the unemployment rate to rise to 4.6% in 2026; if oil prices rise further, the increase in the unemployment rate will be greater.

Previous mainstream economic research also held the view that central banks should "turn a blind eye" to temporary energy price shocks, for reasons similar to tariff shocks. Because oil price shocks are temporary and simultaneously suppress demand, tightening monetary policy would only exacerbate damage to the labor market while doing little to control inflation.

This is one of the reasons why the Federal Reserve and other major central banks pay more attention to core inflation than to overall inflation.

Lack of "Fueling" Conditions in the Economic Fundamentals, Low Probability of Inflation's Secondary Diffusion

Goldman Sachs emphasizes that the current macroeconomic environment makes the probability of large-scale inflationary second-round effects extremely low.

Looking back at history, the severe inflation periods of the 1970s and 2021-2022 shared a common characteristic: an extremely tight labor market and accelerating wage growth.

In the 1970s, this overheated state had persisted for many years before the first major oil price shock in 1973. The expansionary fiscal policy of the 1960s had already pushed the economy to the brink of overheating as it entered the 1970s; the massive fiscal stimulus in 2020-2021 played a similar role.

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

Based on a model built with data from G10 countries, Goldman Sachs believes that when the labor market is relatively loose, long-term inflation expectations are anchored, and fiscal policy is less expansionary, the probability of supply-side shocks leading to persistently high core inflation is significantly reduced.

Monetary Policy Starting from a More Neutral Stance, Higher Bar for Rate Hikes

The starting point of current monetary policy is fundamentally different from the previous two major inflation events.

Currently, the Federal Reserve's federal funds rate is 50-75 basis points higher than the median estimate of the neutral rate in the Federal Reserve's Summary of Economic Projections (SEP), and it is broadly consistent with the recommendations of standard policy rules.

In contrast, at the beginning of 2021-2022, the federal funds rate was at zero, significantly below the neutral rate; the same was true in the 1970s, where the policy rate was far below neutral levels and policy rule recommendations.

Furthermore, since the outbreak of the conflict, financial conditions have tightened by about 80 basis points, further reducing the need for active monetary policy tightening.

The Federal Reserve Has Historically Never Raised Interest Rates Solely Due to Oil Price Shocks

Goldman Sachs' historical analysis shows no significant correlation between oil price shocks mentioned in Federal Reserve officials' speeches and signals of tightening policy, while European Central Bank officials have shown a strong correlation.

From the scenario analyses reported by Federal Reserve staff to the FOMC, under oil price increase scenarios, staff forecasts typically show: overall inflation rising, core inflation rising slightly, economic growth declining, and unemployment rising, but the federal funds rate remaining unchanged relative to the baseline forecast.

At the same time, neither FOMC members nor the Federal Reserve Chair have systematically raised their policy rate forecasts due to oil price shocks historically.

Furthermore, historical data shows that in previous recessions that preceded oil price spikes, the FOMC lowered its policy rate by about 3.5 percentage points. Goldman Sachs has now raised its probability of a recession in the next 12 months by 10 percentage points to 30%, and expects the Federal Reserve to initiate rate cuts once a recession occurs.

Overall, Goldman Sachs believes that the current situation differs fundamentally from the "high-risk" backgrounds of the 1970s and 2021-2022.

Regardless of the scale and breadth of supply shocks, the starting point of economic fundamentals, the initial stance of monetary policy, and the historical reactions of the Federal Reserve, the threshold for rate hikes in this cycle is far higher than what current market pricing reflects.