Rising oil prices may not necessarily lead the Federal Reserve to turn hawkish? Bank of America: It could also cut interest rates significantly!

Bank of America warned on Tuesday that investors betting on the Federal Reserve taking hawkish measures to combat rising oil prices may be misjudging the Fed’s intentions. The bank noted that supply shocks could also keep interest rates stable or even lead to significant cuts.

Since the outbreak of the US-Iran war, the two-year U.S. Treasury yield has moved in tandem with soaring oil prices, reflecting market expectations of rising borrowing costs. However, Bank of America economist Aditya Bhave warned that these expectations “may be incorrect.”

He believes that energy shocks do not necessarily mean tighter policy, as they could create a conflict between the Fed’s dual mandates to stabilize prices and support employment.

In his report on Tuesday, he wrote: “This will deepen the tail risks of policy distribution: there is a risk of maintaining interest rates unchanged in the long term, as well as tail risks of rate hikes, while the risk of large rate cuts is also increasing.”

Market data shows that since the beginning of this month, short-term U.S. bond yields have surged by about 20 basis points. Traders currently expect a 40 basis point cut from the Fed this year, compared to expectations of over 60 basis points before the US-Iran conflict erupted.

After surpassing $100 per barrel in the previous trading day, oil prices saw a sharp decline on Tuesday. However, tensions in the Middle East still appear unresolved, with multiple oil-producing countries reducing output, and the Strait of Hormuz remains a near-stalled shipping bottleneck.

Bhave pointed out that the current market reaction is almost identical to that during the Russia-Ukraine conflict in 2022. He emphasized that at that time, U.S. unemployment was lower, and consumers had substantial stimulus funds.

“Now, the labor market is weak, inflation is rising modestly, and fiscal support has waned,” he said. “If oil shocks persist, the Fed may adopt a more dovish response.”

This week, the focus of U.S. economic data will be on the February CPI report to be released on Wednesday. Economists surveyed by the media predict a median core CPI increase of 0.2% for the month, with overall CPI expected to rise 0.3% month-over-month.

Citi economist Andrew Hollenhorst noted in a Tuesday report that with oil prices falling yesterday, the two-year Treasury yield is only about 10 basis points higher than in late February, suggesting some correlation with recent economic data may re-emerge. The bank expects core inflation to increase by 0.23% month-over-month, well below February last year, confirming a slowdown in core inflation.

“Rising oil prices mean overall inflation is increasing, but if the rise is temporary, its pass-through to core inflation will be limited,” Hollenhorst said.

(Article source: Caixin)