Tariffs might represent an adverse supply shock that lifts inflation and lowers growth but this takes time to come through.

The US is in the throes of experiencing an adverse supply shock from tariffs, and arguably migrant deportations as well. And now, on top of this comes another potential adverse supply shock in the shape of a surge in oil prices. If sustained, higher prices could redouble the difficulties facing the Fed when it comes to choosing the appropriate monetary direction. The ‘do nothing’ option has already become the policy response of choice so far this year, but sooner or later, the Fed will have to choose which way to jump and it may choose the wrong way.

Tariffs might represent an adverse supply shock that lifts inflation and lowers growth, but this takes time to come through. For instance, we’d probably expect the higher inflation to show up first, but it has not done so as yet. In addition, while economic models might be able to hint at what we might call the direct impact of tariffs as import prices rise and demand falls, there is also the rather chaotic way that tariffs have been introduced. This has lifted policy uncertainty dramatically and may cause a sort of sudden-stop in growth before we see any significant inflation materialize. But atop this uncertainty, there could be a new complication bought about by a sustained rise in oil prices as, this too counts as an adverse supply shock.

Now admittedly, it might prove a bigger adverse supply shock to those countries and regions that do not have their own energy supply. Nonetheless, persistent oil price strength could provide an extra level of uncertainty for the Fed – and hence the financial markets. The key here is clearly this word ‘persistent’. For what we have seen in the recent past is that conflicts between countries in the Middle East have not impacted oil supply and hence their ability to lift oil prices sustainably has been limited at best. And, of top of this, we also have to bear in mind that the global economy – and hence global energy demand – has been in retreat.

Hence, the Fed’s temptation might be to think that this latest surge in oil prices will prove as fleeting as the rest. But even if it does not, we tend to find that central bankers usually try to look through the inflationary implications of adverse supply shocks and, instead, focus on their growth-sapping qualities instead. This certainly seems to be the Fed’s bias right now and something that the market seems to go along with given that no rate hikes are priced into the Fed funds futures curve.

Instead, rate cuts are predicted for later in the year as the economy presumably withers under the weight of adverse supply shocks. But is this the right way to go? If we look back at Covid-19, for instance, this adverse supply shock coincided with an adverse demand shock (people could not leave their houses for a time) and this initially lowered inflation. But once restrictions were lifted, demand flooded back far faster than supply and the result was surging inflation.

Initially, the Fed tried to look through this increase in inflation by suggesting that the rise in prices was transitory. In the end, the Fed – and other central banks – were forced to see the rise in prices as more than transitory and they hiked policy rates dramatically. The question now is whether the Fed could be making the same mistake again by not considering rate hikes at this stage.

“We don’t doubt that it is hard to think about rate hikes right now as there is limited evidence that tariffs have lifted prices so far and there is uncertainty as to whether the surge in energy prices will stick. So, for now, at least, expect the ‘do nothing’ policy to prevail. But what if oil prices do continue to climb, and what if we do start to see tariff-related price pressure come through? Will the Fed hike rates, especially if the labour market has not cracked? We somehow suspect not. It might have been a mistake to suggest inflation was transitory before, in 2022, but we suspect that the Fed is most likely to make the same mistake again”, said Steven Barrow, Head of Standard Bank G10 Strategy.