Viewpoints

This note assesses how the surge in oil prices affects inflation and the general price level, and how the Fed may respond.

The general price level is the cost of a basket of goods and services in either the Consumer Price Index or the Personal Consumption Price Index. (For both baskets, the Bureau of Economic Analysis adjusts retail prices of goods and services for estimated changes in quality). Inflation measures the percentage increase in either the CPI or PCE Price Index; deflation measures the percentage decline in the index. Chart 1 shows the monthly percentage changes in the CPI and PCE Price Index in the last several years and Chart 2 shows the yr/yr change.

As is well known, the oil price spike is a negative supply shock that dents the real economy and generates a one-time rise in the general price level that temporarily raises the monthly inflation data but is not inflationary. How long are these temporary impacts expected to last? This depends largely on how long the oil prices stay high. But so far, the rapid responses of retail energy prices to the spike in crude oil prices suggest that the impact on the monthly inflation data will run their course quickly, in 2-3 months. The monthly inflation data should subsequently simmer down to their pre-Middle East conflict pace of increase, while the year-over-year percentage increases in measured inflation absorb the temporary bulge. If oil prices fall back to their pre-conflict $65/barrel, then the monthly changes will turn negative and the general price level will recede to the level its pre-conflict rate of increase would have taken it.

The oil price spike raises costs of energy, so consumers will spend more for energy products (historically, the demand is fairly price inelastic in the short run) and will have less to spend on non-energy goods and services. The oil price bulge and Middle East conflict has hit confidence and raised uncertainty (the University of Michigan consumer sentiment index fell sharply in its latest April meeting) and interest rates a bit. In addition, the higher energy costs will raise business operating costs, which may raise the prices of selected consumer products a bit. As a result, the oil price spike will generate a deceleration of nominal GDP. A larger portion of that aggregate demand will be inflation and a lower portion real.

The Fed properly recognized the oil price spike as a negative supply shock and wisely decided to keep monetary policy on hold at its March FOMC meeting. The Fed funds futures market expects the Fed will be on hold at its late April meeting, which is scheduled to be Chair Powell’s last. The Fed rarely admits mistakes, but it largely acknowledges that its accommodation of the oil price shocks of the 1979s contributed to persistently excess demand and dangerously high inflation and inflationary expectations and bond yields.

Two observations are important about the recent spike in oil prices. First, reflecting the U.S. shale revolution and surge in production of oil and natural gas, which has made the U.S. net energy independent in the aggregate (even though certain regions in the nation have regulations that constrain oil drilling and refining and distribution, forcing them to rely heavily on imported energy—particularly California), gasoline and other energy sources remain in ready supply—only at higher costs. That’s starkly different than the 1970s, when gasoline was scarce and rationed.

Second, retail energy prices have been adjusting quickly to the higher oil prices. As shown in Chart 1, through April 10, while oil prices have risen to $96.50/barrel from $65, a 48% increase, retail gasoline prices nationally have risen to $4.15/gallon, up from $2.97, a 40% rise. Before the Middle East conflict, there was backwardation in the oil price futures curve—the markets had priced in a gradual decline in oil prices from their then-current prices. (After the oil price surge, markets have priced in expectations that prices will fall back toward their earlier price level by later in 2026, but maintain a risk premium.) Prices of other refined oil products have risen even faster: diesel fuel have risen from $3.75/gallon to $5.68, a 51% increase.

The US economy is neither in a “Golden Age,” as Trump supporters argue, nor is it regularly flirting with recession, as Trump critics argue. In reality, Administration polices have contributed to “stagflation”—a combination of below-trend growth combined with persistent above-target inflation. An even bigger test lies ahead, with a significant risk of a major energy shock.

Presidential report cards

In comparing Presidential regimes, a common approach is to average growth and inflation over the four years in office. Of course, this ignores other drivers of the economy, and the lagged effect of policies from the prior President.

Trump’s Presidency is different. He took “ownership” of the economy out of the gate, with sharp shifts in economic policy. In the process Congress was largely sidelined and Fed policy became secondary. This has been Trump’s economy from the get-go.

Let’s briefly look at how five kinds of policy shifts—trade, immigration, tax cuts, deregulation and war have impacted the demand and the supply-side of the US economy.

Demand damage

The impact of Administration policies on spending and demand has been mixed. The good news is that income tax cuts tend to stimulate consumer spending and corporate tax cuts tend to stimulate investment. Unfortunately, these positive effects have been canceled out by the dramatic increase in consumer and business uncertainty.

The chart below shows a news-based measure of policy uncertainty from Bloom and others. There has been a massive spike in policy uncertainty in general and trade policy uncertainty in particular. The later is much higher than during the first trade war. This has put sand in the gears of the economy, with firms reluctant to hire and invest and households reluctant to spend. This is one of the reasons why business investment, outside of data centers, has remained weak and manufacturing jobs have declined.

State real GDP growth rates in 2025:Q4 ranged from -8.3% in DC to 3.8% in North Dakota. The plunge in DC was related to the federal shutdown (Maryland also had a marked decline). North Dakota was an outlier on the other side, reflecting a pickup farm output. Most states had sluggish growth rates within a point of the nation’s .5%.

Personal income growth rates ranged from -4.0% in North Dakota to Hawaii’s astronomical 41.5%. Hawaii’s gain was the result of a large settlement payment related to the 2023 Maui wildfire. North Dakota’s loss stemmed from a sharp drop in earnings (compensation plus proprietors’ income). Most states saw gains trailing the national growth rate of 3.4%; with the exception of California the larger states typically saw higher growth rates.

On February 28 the US and Israel launched airstrikes on Iran. In retaliation, Iran closed the Straits of Hormuz. By early April the average US price of regular gasoline jumped to $4.11/gallon from $2.93/gallon in February, an increase of 40%.

To put this price shock in historical perspective, I: defined the real price of gasoline as the price index for personal consumption expenditures (PCE) on gasoline (and other motor fuels) over the price index for total PCE; calculated monthly percent changes in this real price of gasoline; weighted each of those changes by the geometric average of the current and lagged monthly shares of nominal gasoline purchases in total nominal PCE; cumulated the weighted price changes from January of 1960 to the present.

On balance, state labor markets were fairly stable in January. Several states had statistically significant gains in payrolls, led by California’s 93,500 (.5 percent) surge. In other large states Texas was up 40,100 and Illinois 18,000-both increases of .3 percent. DC was the only significant drop; down 5,400 (.7 percent). Most other states had insignificant gains (these amounted to more than 20,000 in Florida and New York). As one might expect, most of the DC job loss was in government.

The only state to experience a statistically significant change in its unemployment rate was Florida, which saw a .2 percentage point gain. The highest unemployment rates were in DC (6.7%), California (5.4%), Delaware (5.4%), Nevada (5.3%), New Jersey (5.2%), Oregon (5.2%), Michigan (5.0%), and Washington (5.0%). Alabama, Hawaii, North Dakota, South Dakota, and Vermont had unemployment rates below 3.0%, with Hawaii and South Dakota’s the lowest, both at 2.2%.

Puerto Rico’s unemployment rate was unchanged at 5.7% and the island’s job count edged down 400.

We remain overweight Japanese equities and view the recent market correction as a buying opportunity. The macro backdrop remains constructive: business cycle indicators are firm, corporate profitability is strong, and there are no major systemic risks. Any economic slowdown is likely to be temporary and should be looked through rather than feared.

Business cycle signals reinforce this view (Figure 1). Profit and investment cycles are clearly in an upswing, while borrowing costs remain well contained. The two-year real lending rate, though rising, sits comfortably within its historical range, indicating that the cost of capital is not restrictive. Credit growth is broadly aligned with economic expansion, with signs of strengthening private sector demand. The only soft spot is money supply growth, but even here the recent acceleration reflects a rebound from low levels rather than a structural concern. Overall, the Bank of Japan (BoJ) expects real GDP growth of around 1% annually over the next three years—well above its estimated potential rate of 0.5%.

The US economy is currently facing a major energy shock, and the Federal Reserve needs to apply strategies designed for supply shocks. Yet, the Federal Reserve appears to be operating under the belief that they are still dealing with the long-term impacts of a demand shock. The projections from the March 17-18 Federal Open Market Committee meeting suggest a long-term forecast of official rates at 3% and inflation at 2%, resulting in a real official interest rate of 1%. In today's world, that projected rate is much too low.

Although demand and supply shocks may share characteristics like job losses and wealth destruction, the primary distinction lies in their impact on inflation. Demand shocks generally result in a significant drop in inflation, whereas supply shocks have the opposite impact, leading to price hikes from production through to distribution and retail, which in turn causes both headline consumer inflation and core inflation to rise.

Before the two demand shocks of the early 2000s (the tech bubble and financial crisis), the Fed maintained a real longer-run official rate of 2%, sometimes reaching as high as 3%. Following the demand shocks, particularly the financial crisis, the Fed maintained very low and even negative real official rates, after factoring in the stimulative impacts of the quantitative easing policy.

However, those economic conditions are now a thing of the past. Currently, with core inflaiton at 3% and managing with a nominal official rate in the low mid-3% range during the initial phases of an energy shock, it places monetary policy in a precarious situation, as it increases the risk of prolonged higher inflation. Policymakers aim to avoid the policy errors made after the COVID supply shock, but the political climate might leave them with no alternative.

Therefore, it should come as no surprise that the bond market is sensing more inflation.