February’s Consumer Price Index (CPI) report landed Wednesday morning, and it looked rather tame. Prices rose 2.4% year over year, exactly matching Wall Street’s expectations. Core inflation — which strips out food and energy — came in at 2.5%. Rent posted its smallest monthly increase since January 2021. While the number is still above the Federal Reserve’s target of 2%, it’s not terribly so. But that may soon change.
Here’s the problem: February’s data was collected before the war in Iran began. The oil shock that sent global benchmark Brent crude to $120 per barrel on Monday hasn’t yet shown up in consumer prices. And though oil prices have fallen to roughly $90 a barrel, they’re still more than 30% higher than before the war began. If oil stays elevated — and there is plenty of reason to think it will — future inflation readings aren’t likely to be so tame.
And this is coming at a time when the job market is showing serious signs of weakness: In February, the U.S. lost 92,000 jobs, the second negative print in three months.
Sticky inflation, an oil shock, and a deteriorating labor market — all at once. That’s a combination the economy doesn’t often face, and the market is bracing for how the Federal Reserve will respond. Here’s what investors should know.
The Fed is staring down a tricky problem
The Federal Reserve has two jobs: Keep prices stable and keep employment high. Most of the time, those goals work together. When the economy overheats, the Fed raises interest rates to cool inflation — even if it slows hiring. When the economy weakens, it cuts rates to boost the job market — even if prices creep up a bit. One problem at a time.
Right now, both problems need attention.
On the inflation side, while the most recent consumer data is relatively benign, wholesale prices have been rising and may soon flow into future CPI readings. Last week’s Producer Price Index (PPI) came in well above expectations, rising 0.8% in January — nearly 3 times what Wall Street was targeting.
On the employment side, the most recent report showed the U.S. lost 92,000 jobs in February while revising December’s numbers from a 48,000 gain to a net loss of 17,000. While January’s numbers were strong by comparison, two out of the last three months showing net losses is not great news for the economy.
So, the Fed faces a genuine bind. Cut rates to support the job market, and you risk pouring gasoline on inflation at an already precarious time. Hold rates steady, and employment could deteriorate further. There is no easy answer.
What happens when an oil shock and inflation collide?
Image source: Getty Images.
This isn’t the first time the economy has faced rising energy costs, stubborn inflation, and a struggling economy at the same time.
The most extreme example was the 1973-1974 oil embargo and the 1979 oil crisis; energy prices spiked while inflation was already running hot. But the Fed was slow to respond, keeping rates too low for too long in hopes of protecting the economy. That hesitation backfired.
Inflation spiraled, and the Fed was ultimately forced into the most aggressive rate hikes in its history, tipping the economy into back-to-back recessions. Inflation peaked above 13% in 1980, and the S&P 500 delivered roughly negative 2% per year in real terms across the entire decade from 1973 to 1982.
The 2022 energy shock played out differently — largely because the Fed didn’t repeat that mistake. When oil surged after Russia’s invasion of Ukraine and the CPI hit 9.1%, the Fed moved fast, launching the most aggressive rate-hiking cycle in 40 years. The S&P 500 fell more than 25%, but within a year of bottoming, the market had recovered.
The current situation definitely isn’t identical to either. The oil shocks in the 1970s were more extreme and, at least for now, more sustained. In 2022, the world was still dealing with pandemic supply chain disruptions. But the setup — oil shock plus already sticky inflation plus a weakening labor market — carries echoes of both.
The question is which playbook the Fed runs this time: Move fast and accept short-term pain, or try to wait it out and risk something worse.
What it means for you
The Federal Reserve is in a tight spot. The latest CPI numbers didn’t change that — the oil shock that’s still working its way through the system could make it significantly worse.
And with the Shiller CAPE Ratio — a measure of how expensive the stock market is — hovering just below 40, just shy of its dot-com peak, there isn’t much cushion built into stock prices for bad news.
The most important thing long-term investors can do right now is make sure they aren’t overexposed to risky, speculative stocks whose stock prices rely on unbridled optimism.
