Behind the "breaking 4" in gasoline prices: The Federal Reserve is actually less willing to raise interest rates and may have to cut rates instead?

At the start of this week, the average retail gasoline price across the United States has officially broken through $4 per gallon. This reflects the ongoing supply shocks affecting the energy market. What’s interesting, though, is that while this would seem like the kind of signal that the Federal Reserve should use to justify raising rates to curb inflation, at least for now the answer may be exactly the opposite……

On Tuesday, investors instead expected the Federal Reserve to hold the benchmark interest rate steady, and even possibly shift to rate cuts later this year, because policymakers are likely to weigh the risks brought by rising energy prices—risks that may do more to drag economic growth than to trigger persistent inflation.

In remarks delivered on Monday—remarks that could influence market direction—Federal Reserve Chair Jerome Powell also hinted that, for an economy already facing weakening labor markets and increasing worries on Wall Street about an economic recession, raising rates at this time may not be a cure-all. When asked whether he thought policymakers should consider hiking rates now, Powell replied, “By the time the effects of monetary policy tightening show up, the oil price shock may have already passed—and you would be putting pressure on the economy at the wrong time. Therefore, our inclination is to ignore any form of supply shock.”

These remarks were published at a critical juncture for the market. Previously, due to a series of conflicting and constantly shifting economic signals, the market had struggled to discern the Federal Reserve’s true intentions. Just last week, traders were still seriously considering whether the next move by the Federal Reserve could involve the risk of raising rates.

However, Powell’s comments—despite the Fed’s customary smooth style, under which rate hikes or rate cuts are both possible—still helped the market step back from a hawkish stance. Bond traders largely abandoned bets on rising inflation and instead focused on the impact that high oil prices could have on economic growth.

As shown in the figure below, at the beginning of last week, the futures market generally still priced in that a rate hike before the end of the year was essentially a done deal. Now, the interest rate swap market indicates that the size of rate cuts by the end of 2026 is about 6 basis points, roughly equivalent to a 25% probability. Ian Lyngen, Head of U.S. Rates Strategy at BMO Capital Markets, said that investors “now view the risks to global economic growth from an energy shock as equally important as—or even more important than—concerns about inflation.”

This dramatic shift is evident in the options market for overnight secured financing rate (SOFR), a rate closely tied to central bank policy expectations. On Monday, data on open interest (i.e., the risk exposure held by traders) showed that a large number of hawkish positions hedging expectations for the Fed’s imminent rate hikes appear to have been closed, resulting in losses.

Trade inflation, stabilize the economy?

In his latest report, Rob Subbaraman, Head of Global Macro Research at Nomura Securities, wrote that when dealing with high prices, central bank officials will ultimately be “sharp in words, but slow in action.”

He added, “At present, with overall inflation surging, a strategy of holding steady but maintaining a hawkish stance helps stabilize inflation expectations, which makes sense. However…… the pass-through effect of higher oil prices on wage growth and core inflation may be limited. Instead, the Middle East war could quickly evolve into a global economic growth shock.”

In fact, concerns within the industry in recent days about what impact the surge in oil prices could have on economic growth have gone beyond worries about inflation itself—aligning with Powell’s view—that raising rates can’t solve the problem of energy costs now, and could instead create even more trouble in the future. What policymakers are more concerned about is not the direct shock caused by energy-driven inflation, but the risk that rising prices could weaken consumer demand and employment.

Joseph Brusuelas, Chief Economist at RSM, said that central bank decision-makers should be wary of “demand destruction” triggered by an energy shock.

“Time isn’t friendly to the U.S. economy,” he wrote in the article. “The bigger risk is what will happen next: demand destruction. This is the term economists use to describe the phenomenon in which high prices force individuals and businesses to cut back on spending. It sounds abstract, but it’s actually very concrete—that means fewer car sales, fewer home purchases, fewer meals out, and less business investment, ultimately leading to fewer jobs.”

Brusuelas added that the Federal Reserve is currently stuck in a policy dilemma: raising rates now could further weigh on economic growth, while staying on hold faces the risk of a worsening oil price outlook.

“This is the classic stagflation dilemma, and there’s no perfect solution,” he said. “If the situation deteriorates further, the Federal Reserve will take action. But we think the Federal Reserve is more likely to remain patient, and when it finally takes action, it often ends up lagging the situation, putting further pressure on demand before a large round of rate cuts.”

Jason Thomas, Head of Global Research and Investment Strategy at KKR, also expressed similar concerns, saying the Federal Reserve may not only be forced to cut rates, but the magnitude of the cuts could be larger than its usual 25-basis-point moves.

This dynamic highlights a shift in how the Federal Reserve responds to shocks—not focusing on temporary price spikes anymore, but instead focusing more on broader economic impacts. Thomas wrote, “When a temporary supply shock hits the labor market hard, the Federal Reserve will never stand by. In this economic environment, the earliest rate cuts could start in September, and the size of the rate cuts is likely to exceed 25 basis points.”

（Source: 财联社）