Will high oil prices lead the Federal Reserve to raise interest rates? Goldman Sachs doesn't believe so.

Chasing-the-Wind Trading Desk message: On April 1, Goldman Sachs economist Manuel Abecasis published a research report stating that although market expectations for a rate hike by the Federal Reserve have surged sharply after the U.S.-Iran conflict broke out, the Federal Reserve is unlikely to hike rates in reality.

The report emphasizes that if the economy falls into a recession, the Federal Reserve would most likely still cut rates, and oil-price shocks would not prevent it from taking easing actions. The main reasons are four points:

• The scale and scope of the current oil shock are smaller: Compared with the 1970s, the rise in oil prices today is smaller, and the economy’s reliance on oil has been greatly reduced.
• Different economic starting point; inflation is hard to spread: The labor market is already softening, and wage growth has fallen below the level consistent with the 2% inflation target. Long-term inflation expectations remain stable, which is different from the 1970s scenario where expectations ran out of control.
• Monetary policy starting point is already relatively tight: Since the conflict began, financial conditions have tightened by about 80 basis points, which further reduces the need for additional tightening.
• The Federal Reserve typically does not respond to an oil shock by itself: Historical analysis shows that in remarks by Federal Reserve officials, there is no significant correlation between mentions of an oil-price shock and signals of releasing tightening policy; by contrast, European Central Bank officials show a much stronger correlation.

Goldman Sachs’ baseline forecast still calls for two rate cuts in 2026, and its interest-rate-path projection weighted by probability is more dovish than market pricing.

The scale and breadth of this round of oil-price shock are far less than those of historical crises

Manuel Abecasis noted that even under a “severe adverse scenario” measurement, the magnitude of this round of oil-price shock is still smaller than in the 1970s, and its duration is shorter than in 2021-2022.

More critically, the U.S. economy’s dependence on oil today is far lower than in the 1970s. Based on the data, both the economy’s energy intensity (of GDP) and the share of gasoline in personal consumption expenditures (PCE) have declined significantly versus those years.

On the supply-chain side, although the Iran conflict may disrupt trade corridors in the Middle East and push up prices of some non-oil commodities, so far its impact area is clearly narrower than the large-scale supply disruptions and commodity shortages seen in 2021-2022. Of course, as the conflict continues, there is still uncertainty about the supply-chain outlook.

From the inflation transmission path, higher oil prices will significantly raise overall inflation, while the lift to core inflation is relatively limited, and this shock will fade over time because oil prices will not keep rising year after year.

At the same time, higher oil prices will reduce real disposable income, dragging down economic growth and employment. Goldman Sachs expects the unemployment rate in 2026 to rise to 4.6%; if oil prices rise further, the increase in the unemployment rate would be larger.

Mainstream views from prior economic research have also held that central banks should “ignore” the short-lived shocks to energy prices, for reasons similar to tariff shocks. Because oil-price shocks are temporary and also suppress demand, tightening monetary policy would only worsen damage to the labor market, with little benefit for controlling inflation.

This is one of the reasons the Federal Reserve and other major central banks focus more on core inflation rather than headline inflation.

The macro fundamentals lack “fuel” conditions; the probability of a second-round inflation spread is low

Goldman Sachs emphasizes that the current macro environment makes the probability of large-scale second-round inflation effects extremely low.

Looking back at history, the severe inflation periods in the 1970s and 2021-2022 shared a common feature: the labor market was extremely tight, and wage growth accelerated.

In the 1970s, this overheating condition had persisted for years before the first major oil-price shock arrived in 1973. Expansionary fiscal policy in the 1960s even left the economy near the overheating edge when it entered the 1970s. The large-scale fiscal stimulus in 2020-2021 also played a similar role.

By contrast, today the U.S. labor market is weakening, wage growth has fallen below the level consistent with the 2% inflation target, and long-to-medium-term inflation expectations remain well anchored.

Through modeling using data from G10 countries, Goldman Sachs believes that when the labor market is relatively loose, long-term inflation expectations are anchored, and fiscal policy is less expansionary, the probability that a supply-side shock keeps core inflation rising significantly is notably lower.

A more neutral monetary policy starting point; a higher threshold for rate hikes

The current monetary policy starting point is very different from the past two major inflation episodes.

At present, the Federal Reserve’s federal funds rate is estimated to be 50-75 basis points above the neutral rate midpoint in the Federal Reserve’s Summary of Economic Projections (SEP), and it is broadly consistent with recommendations from standard policy rules.

By comparison, at the start of 2021-2022, the federal funds rate was at the zero-interest-rate level, significantly below the neutral rate; the 1970s were similar, with policy rates far below the neutral level and the values suggested by policy rules.

In addition, since the conflict broke out, financial conditions have tightened by about 80 basis points, further reducing the need for proactively tightening monetary policy.

The Federal Reserve has never historically raised rates solely because of an oil-price shock

Through historical analysis, Goldman Sachs shows that there is no significant correlation between oil-price shock mentions and signals of releasing tightening policy in speeches by Federal Reserve officials, while there is a stronger correlation for European Central Bank officials.

Based on scenario analysis of the FOMC staff reporting to the FOMC, in scenarios where oil prices rise, staff forecasts typically show: headline inflation rises, core inflation rises slightly, economic growth slows, and unemployment rises, but the federal funds rate relative to the baseline forecast remains unchanged.

Meanwhile, neither FOMC participants nor the Federal Reserve Chair have historically systematically raised their policy-rate forecasts due to an oil-price shock.

In addition, historical data show that in each recession preceding the spikes in oil prices, the FOMC lowered the policy rate by about 3.5 percentage points. Goldman Sachs has currently raised the probability of a recession over the next 12 months by 10 percentage points to 30%, and it expects that once a recession occurs, the Federal Reserve will begin cutting rates.

Overall, Goldman Sachs believes there are fundamental differences between the current scenario and the “high-risk” backdrop of the 1970s and 2021-2022.

Whether looking at the scale and breadth of the supply shock, the starting point of economic fundamentals, the initial stance of monetary policy, or the Federal Reserve’s historical response, the threshold for rate hikes in this cycle is far higher than what current market pricing reflects.

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