Have tumbling oil prices undone the Federal Reserve’s tariff conundrum?

The Federal Reserve has framed tariffs as something of a conundrum.

Levies on imports push prices higher and activity lower, seemingly making it more difficult for the central bank to achieve both parts of its dual mandate.

The nature of this risk, coupled with the fact that the economy came into this shock in a position that can be characterized from a range of “slowing but solid by historical standards” to “displaying concerning trends, but not obviously weak,” has provided little urgency for the central bank to act. Monetary policymakers release their latest rate decision at 2 p.m. ET on Wednesday, with economists anticipating no change to the policy rate of 4.25% to 4.5%.

But Neil Dutta, head of US economics at Renaissance Macro Research, raises an interesting point that challenges the Fed’s narrative.

In the short term, the inflationary shock from tariffs isn’t manifesting too quickly. Meanwhile, we’ve already received a positive supply shock in the form of lower oil prices. So why not cut sooner rather than later, given that the economy was largely on a softening path before tariffs entered the landscape and the inflation outlook isn’t ringing crescendoing alarm bells in the near term?

Dutta writes:

“Oil is not the main driver of inflation but tends to play an outsized role on the month-to-month swings in headline consumer prices. If I run a simple estimate mapping changes in oil prices to headline inflation, it’s possible that we see headline consumer prices flat to slightly down over the next couple of months. Note that lower diesel prices will also bleed into food.

I find the optics interesting.

There is a good chance we get some soft headline inflation prints over the next couple of months. Does the Fed really want to be sitting on its hands while headline price inflation comes in soft? That will be a tough one to explain away, especially considering energy & food tend to be more important to setting household inflation expectations.”

Gasoline prices are down about 13% year on year. And oil prices have fallen not primarily due to concerns about a weakening economy, but because of expanded supply from OPEC+. (As an aside, just like Taiwan’s currency surge, the OPEC+ production jump should be considered as a quasi-geopolitical development that has a vague but real link to countries’ desires not to get embroiled in a trade war with the US.)

We can tell the oil move is more supply than demand because crack spreads — that is, the difference between crude prices and refined products — have been stable even as West Texas Intermediate front-month futures tumbled to below $60 per barrel since the April 2 reciprocal tariffs announcement. That’s a signal that the supply of the commodity is driving the bus rather than end-user demand.

Skanda Amarnath, executive director of Employ America, adds that we might be in the “eye of the storm” from an inflation perspective, though he doubts that the energy price dynamic specifically will drive the Fed’s decision-making. He’s focused more on the prospect of firms being not too trigger-happy on price increases until there’s more visibility on the trade outlook.

“The case for benign inflation in the second quarter is quite good because firms don’t know what trade policy is and whether it’s going to stick or there will be deals — there’s a range of possibilities there,” he said. “But by the end of June, with the 90-day pause on reciprocal tariffs lapsing, firms will see how many deals or frameworks of deals are in place by that point, and may have a better idea of what’s sticking.”

Consider Ford, for instance. The US automaker is offering discounts on vehicles through Independence Day, but after that, prices are likely heading higher after vehicles produced in a newly tariff’d world arrive on lots.

But there is one glaring issue with Dutta’s case, at least in terms of explaining why the oil price drop may not meaningfully enter the Federal Reserve’s calculus.

The US central bank is loath to react to changes in headline inflation. That’s why the central bank uses core measures of inflation as a gauge of underlying price pressures in the economy. When Fed officials are influenced by changes in gasoline prices, it’s typically because of a bank shot effect: they’re not worried about the headline inflationary impact, but because high energy prices are forcing inflation expectations higher. Since the expectations channel is thought to be a key mechanism that allows monetary policymakers to achieve their inflation goal over the medium term, that’s something they’re willing to go to the mat to protect.

But unlike 2022, when surging gasoline prices drove inflation expectations higher and pushed the US central bank into a particularly aggressive tightening stance, consumers’ inflation expectations are going up while oil prices go down.

“The expectations channel versus gasoline prices really doesn’t work as much in both directions,” Peter Williams, an economist at 22V Research, said. “People notice higher energy prices, but don’t really react to them on the way down.”

“Energy prices used to be the only prominent component in people’s consumption baskets that is very volatile, and this is no longer the case,” Williams added. “A lot of our heuristics about how energy prices influence inflation expectations really apply to volatile prices they see frequently, and a lot of those are pushing in the opposite direction — higher.”

So the Federal Reserve’s surface-level conundrum, it seems, is being reinforced by the inflation expectations channel more so than it is being undone by the positive supply shock from lower energy prices.

But in an interesting twist, the fall in oil prices might push the Fed toward action in another way. As the old saying goes, the best cure for low prices is low prices. And low energy prices might not last because US producers may turn off their taps to adjust to a world awash in OPEC+ crude. This week, Diamondback Energy and Coterra Energy cut their production estimates, and a look at any business commentary out of the Lone Star State lately reads like Texas-sized nightmare fuel.

“One reason why the Fed might be nudged toward earlier action because of low oil prices is less about headline inflation and more about pain among US crude producers adding to concerns for manufacturers,” Williams said.

For what it’s worth, the market’s pricing of inflation continues to suggest that any tariff-driven inflation will not be a long-lived phenomenon.

Since the below measures are in CPI terms, which tend to run about 40 to 50 basis points hotter than PCE (the Fed’s preferred inflation gauge), we can say that at no point since the April 2 reciprocal tariff announcement has inflation been priced to be above the central bank’s target for more than a one-year period. In this writer’s judgement, at least, this further reduces the argument for caring as much about what tariffs will do to prices compared to the negatives for US economic activity, and by extension, the labor market.

So, in sum: the Federal Reserve can probably take heart in the near-term inflation outlook, then has a lot of reason to care about high inflation ~3 to 15 months down the road, and then back to having not much reason to worry about inflation after that.

How all this time frame inconsistency will enter the policymaking equation in real time and be balanced against the outlook for the labor market is anyone’s guess, and hopefully something we’ll get more color on this afternoon.