The Russian invasion of Ukraine has sent oil prices skyrocketing to their highest level since 2008. In fewer than 10 days, oil prices have increased by 30%, surpassing our recent base-line model for a 20% oil price shock, which we estimated would push inflation above 10% this year.
The energy shock, however, will have a disproportionate impact on lower-income Americans who have been hit hardest by the pandemic.
Despite such a significant price shock, the Federal Reserve should not overreact by hiking interest rates aggressively because the spillovers from higher energy prices on core goods and services will most likely be relatively small and fade quickly, given the current economic and geopolitical situation.
We expect the Fed will look through such volatility while remaining ready to act swiftly when needed. The priority at the moment is to craft a soft landing for the economy as the shock of the pandemic recedes.
We expect the central bank will lift rates by 25 basis points at its March meeting and then three to four more times this year depending on inflation, geopolitical tensions and the Fed’s judgment on demand destruction caused by surging energy prices.
There will be, however, a disproportionate impact on Americans who occupy the middle, working and low- income brackets that have been hardest hit by the pandemic. The energy shock, therefore, will require the government to adopt more policies to mitigate any social and political impacts that will follow.
An economy less dependent on oil
The notion that the economy is experiencing a shock similar to the oil shocks of the 1970s and 1980s often fails to consider the remarkable transformation of the economy away from its heavy dependence on oil products.
Since 1962, the share of consumption spending on gasoline and other energy products has been cut in half, from around 5% to 2.5%.
Even when the price of oil reached $140 per barrel in 2008, the highest on record, the share of spending on gasoline and other energy products never came close to 6%, the level during the 1970s and 80s stagflation period.
That should not come as a surprise because of the development of nuclear energy and, more recently, renewable energy that have in recent decades eased the dependence on oil.
That transformation has helped the economy to rely less on oil products, while driving the cost of energy down significantly. And that is the reason why the U.S. economy is in a much better position to absorb the energy shock coming from the current geopolitical conflict on the other side of the Atlantic Ocean.
The same also applies to the relationship between energy prices and core goods and services prices. Less reliance means that there are fewer pass-through effects from energy prices in the core components of inflation.
From 1970 to 2008, the positive relationship between the energy goods consumer price index and the core CPI was undeniable. Higher energy prices usually led to higher core goods and services prices because of higher production costs.
But that relationship has broken down in the past 14 years, staying flat despite the extreme fluctuation of energy prices during those years.
Once again, the breakdown of that relationship should make a strong case for the Fed to look past the impact of the energy shock on the headline inflation number, while keeping an eye on other core components of the inflation index that are more pressing like housing, automobiles and, at the same time, wage inflation.
Still, the consequences of the energy shock will affect most Americans, especially those in the lower end of the income spectrum.
The difference in the share of spending on energy goods is significant between the bottom 20% of income earners, who spent 8% on energy goods, and the top 20% , who spent only 4%, according to the most recent data from the Bureau of Labor Statistics on spending composition in 2020.
On top of that, low-income families have fewer options for substitutes when it comes to energy spending. Not everyone can afford to switch to an electric vehicle or install a solar energy system. Low-income Americans also do not have the luxury of spending less on energy goods since most of their spending is on necessities that cannot be reduced without significantly affecting their quality of life.
The takeaway
There is nothing that the Fed can do to alleviate such an impact, which will certainly put more pressure on low-income households that have been hit hardest by the pandemic.
The government, though, can ease the economic and social burden of the energy shock on Americans with substantial policies that target the most vulnerable parts of the population.
