The path of U.S. monetary policy hinges critically on oil prices. Unless geopolitical tensions ease quickly and oil prices fall rapidly, a moderate rate-cutting path appears unlikely. The higher oil prices climb and the longer they remain elevated, the more probable it becomes that the Federal Reserve will face a binary choice: either refrain from cutting interest rates altogether—or even consider raising them—or implement more substantial rate cuts. The decisive factor will be whether long-term inflation expectations rise significantly.

Should long-term inflation expectations surge due to soaring oil prices, the Fed may find it difficult to cut rates this year, with interest rate hikes becoming a possibility in extreme scenarios. Research from the Federal Reserve System indicates that unanchored inflation expectations pose a systemic, persistent, and costly threat, not merely a risk equivalent to rising unemployment. While balancing the dual mandate is complex, maintaining anchored inflation expectations is a primary objective. If the risk of de-anchoring rises, policy may need to remain hawkish, even at the cost of short-term employment.

Conversely, if long-term inflation expectations remain stable despite high oil prices, the Fed may still need to cut rates this year. The higher and more prolonged the oil price shock, the greater the required magnitude of rate cuts may be. Persistently high oil prices could significantly impact U.S. household living costs and consumption. Two quantitative perspectives illustrate this:

First, the negative effect of rising oil prices on consumption. At a micro level, a 2022 survey by the American Automobile Association found that when retail gasoline prices exceed $4 per gallon (corresponding to Brent crude above approximately $110 per barrel), 64% of respondents change their driving habits or lifestyles, such as driving less, combining errands, or reducing shopping and dining. At a macro level, a 10% increase in retail gasoline prices reduces gasoline consumption by about 2–3%, dragging overall consumption down by approximately 0.06 percentage points. As of the week of March 16, retail gasoline prices had risen about 43% compared to late February. Static estimates suggest this could reduce consumption by around 0.27 percentage points, not accounting for the crowding-out effect on other spending.

Second, wealth effect losses from risk asset declines due to heightened market volatility and tightening liquidity amid oil price surges. A core concern is that a drop in U.S. stock prices could impact consumption among high-income groups, which has been most resilient. With total U.S. stock market capitalization around $70 trillion, a 10% decline implies a $7 trillion wealth loss. Based on the marginal propensity to consume for high-income households (an additional $0.008 consumed per $1 increase in equity wealth), this could reduce consumption by approximately 0.3%. If a higher marginal propensity to consume (e.g., $0.04–$0.05) is applied across all households, the drag could be larger.

Tracking changes in long-term inflation expectations is crucial. Two key questions arise: which indicators to use, and what level of increase might concern the Fed?

For the first question, given timeliness and common usage, market-based measures like the 5-year, 5-year forward inflation swap rate and the 10-year breakeven inflation rate are suitable for tracking.

For the second question, a rough estimate suggests the Fed might become concerned if these indicators approach 2.8–3%, corresponding to a rapid short-term increase of about 50 basis points. While Fed officials have not specified a quantitative threshold, references to 2022 remarks by Chair Powell indicate that sustained rises in long-term expectations are worrisome. Currently, these indicators remain around 2.4%, broadly stable compared to February.

What does the "Be More or Not to Be" scenario imply for risk assets? Since March, market rate-cut expectations have largely moved with oil prices. Amid geopolitical uncertainty and concerns over "high oil prices–high inflation–difficult rate cuts," a "sell first, ask questions later" mentality has led to noticeable liquidity shocks. Aside from oil-related commodities and the U.S. dollar, risk assets and gold have faced simultaneous pressure, with gold potentially being sold to raise liquidity, exacerbating its decline.

Looking ahead, if long-term inflation expectations remain stable and signs emerge that liquidity shock risks are easing (simplest observed through a decline in the VIX index), rate-cut expectations could swing back and intensify significantly, leading to a substantial reversal in current market pricing toward anticipating cuts.

If long-term inflation expectations rise rapidly and stay high, whether current market pricing is complete (expectations for cuts this year have already fallen to zero) would require dynamic assessment based on specific conditions and Fed communications.

Regarding the March FOMC meeting, the committee paused rate cuts, maintaining the federal funds target range at 3.5%–3.75%, aligning with market expectations. The statement noted that the implications of Middle East developments for the U.S. economy are uncertain. Economic projections were revised upward for growth and inflation, while the median dot plot continued to indicate one rate cut this year, unchanged from December. Chair Powell emphasized uncertainty stemming from Middle East conflict-induced energy price increases, noting that while long-term inflation expectations remain anchored, the Fed must proceed cautiously given recent high inflation. He also stated that the current policy rate is broadly appropriate, situated near the high end of the neutral range or slightly restrictive.