Oil prices soar = hawkish Fed? Bank of America: The market may be misjudging, the 2022 scenario is unlikely to repeat

Oil price increases do not necessarily mean the Federal Reserve will turn hawkish, Bank of America Merrill Lynch warns that the market is making a wrong interpretation of the Fed’s policy response. Since the outbreak of the Iran conflict, the yield on 2-year US Treasury bonds has climbed in tandem with oil prices, and the market is directly pricing supply-side shocks as a signal for monetary policy tightening. According to Bank of America Merrill Lynch’s morning market report released on March 10, this logic has a fundamental flaw: supply shocks threaten both ends of the Fed’s dual mandate simultaneously, expanding policy uncertainty in both directions, rather than just a one-sided hawkish tilt. Bank of America Merrill Lynch US economist Aditya Bhave points out that the current macro environment is completely different from 2022—a softer labor market, moderate inflation, and limited fiscal stimulus. If the oil price shock persists, the Fed’s response is more likely to be dovish instead of replaying the aggressive rate hike path of 2022. Market is directly pricing oil price increases as hawkish signals Since the Iran conflict broke out, the yield of 2-year US Treasuries and WTI crude oil prices have moved in close alignment. The implied market logic is: rising oil prices push up inflation expectations, which in turn forces the Fed to keep rates high or even restart hikes. The only exception came on the Friday after weak nonfarm payroll data in February, when yields temporarily diverged from oil price movements. Bank of America Merrill Lynch believes this pricing method overlooks the dual nature of supply shocks. Supply-side shocks not only push up inflation, but also suppress economic growth and employment, exerting opposing pressures on the Fed’s dual mandate—price stability and full employment. This pressure makes the “tails” of the policy distribution thicker: the probability of a prolonged rate pause increases, there is tail risk of rate hikes, but substantial rate cuts are also possible and cannot be ignored. Why the 2022 playbook is hard to replicate Bank of America Merrill Lynch emphasizes that the premise for right-tail policy risk (i.e., the Fed turning hawkish due to rising oil prices) is strong economic demand, which can withstand supply shocks without significant slowdown, allowing the Fed to focus on inflation. When the Russia-Ukraine conflict broke out in 2022, this condition was met: unemployment was below 4%, core PCE inflation above 5%, monthly nonfarm jobs gains around 500,000, and consumers had substantial cash from pandemic-era fiscal subsidies. The current situation is in stark contrast. Bank of America Merrill Lynch points out that the labor market is now softer, inflation is at a moderately elevated level, and fiscal support is relatively limited. Against this backdrop, if the oil price shock is persistent, the Fed is more likely to respond dovishly instead of tightening policy as the market expects. Policy uncertainty expands in both directions The core judgment from Bank of America Merrill Lynch is that rising oil prices “thicken both tails of the policy distribution” rather than pushing probabilities solely toward the hawkish side. Specifically, a longer rate pause becomes more likely, rate hikes remain as tail risks, but if the supply shock continues to drag on growth, the risk of deep rate cuts also rises. The current macro fundamentals mean the Fed’s sensitivity to oil price shocks is very different from 2022. If the market continues to price using the old playbook, it may risk a directional misread. At the macro data level, Bank of America Merrill Lynch has lowered its Q1 GDP tracking estimate from the previous official forecast of 3.3% to 2.9% (seasonally adjusted annualized rate), mainly due to weaker-than-expected January retail sales and February nonfarm payrolls. Personal consumption expenditure tracking has fallen from 2.2% to 1.8%, and residential investment from 1.5% to 1.0%. Risk Warning and Disclaimer Markets have risks; investment requires caution. This article does not constitute personal investment advice and does not take into account users’ individual investment objectives, financial situations, or needs. Users should consider whether any opinions, views, or conclusions in this article fit their specific circumstances. Investments based on this are at your own risk.