The price of oil is perhaps the classic example of supply shocks the Fed would tend to “look through.” Why does this time feel different?

Typically, we’re looking at core inflation that strips out food and energy, the idea being that energy is volatile, you can have some of these short-run disruptions, and we want to understand whether the underlying rate of inflation is close to our inflation target.

Neil Mehrotra Assistant Vice President and Policy Advisor

The concern with this shock is twofold. One is, it’s very big. So, there’s going to be some pass-through of changes in oil prices to core prices. We can think about some direct channels through which this happens: Jet fuel prices go straight into airfares, and that’s a component of core inflation. Diesel is the primary means through which we truck goods—that will show up in core inflation eventually.

The other concern is that we are already above target in terms of inflation and we’ve been above target for a while now. There’s concern about pass-through into underlying inflation if the factors that have been keeping inflation high prior to the war are still sticking around. A world where we had been at 2 percent inflation would feel a little different than this world where we have been at 3 percent inflation for a couple of years.

You have also pointed out that this is about more than oil. It has turned out to involve helium—which is apparently essential for AI data centers—fertilizer, and a lot of other trade that is disrupted.

When you’re thinking about effects of this shock filtering through into broader measures of prices, potentially it could have serious implications for products where there’s no easy way to substitute. There was news this morning about aluminum becoming in shorter supply because the Persian Gulf accounts for one-sixth of global aluminum exports. You have important effects on the food supply chain through fertilizer, since natural gas is used to make ammonia. Sulfur is a byproduct of the gas and oil refining process and is also used for making fertilizer. All these potential commodities could have material downstream effects. We’re uncertain about how large and how long that would take to play out.

How might policymakers think about the tipping point between looking through the shock and integrating it into policy?

Policymakers are probably going to be most attentive to measures of inflation expectations. Because there it doesn’t quite matter whether it’s headline or whether it’s core, whether it’s driven by energy or some of these other commodities, or whether it’s driven by things that happened in the past. Particularly if long-term inflation expectations are rising, policymakers need to take actions to keep expectations anchored.

Whether and when the Strait of Hormuz reopens is going to be an important indicator for policymakers. If you don’t see anything happening in the next couple weeks, I think policymakers are going to be following that meeting by meeting. In terms of data, core PCE [personal consumption expenditures] inflation rose to 3.2 percent, on a year-over-year basis through March. So, the data-dependence is going to remain there.

And, as Chair [Jerome] Powell talked about in his press conference, they’re expecting to see tariff effects diminish in the coming months. If that doesn’t happen—be it because of these events, or because of some of the things that Mike Waugh and I recently wrote about in terms of tariff effects being overestimated or maybe not fully incorporated yet—I think policymakers will take note of that.

How do you foresee the impact of the United Arab Emirates leaving OPEC—and maybe the erosion, steady or quick, of the OPEC cartel’s power?

The UAE is a major exporter of oil. In the long run this may lead to a situation where OPEC disintegrates, and you have more of a free-for-all in the oil market. That would tend to drive the price lower.

But even if the Strait of Hormuz opens tomorrow there are by some estimates as much as 1 billion barrels of production that have been lost—that’s a couple percent of annual, global oil production. That hole in inventories has to be refilled, and so for some period the price of oil is going to be elevated. The UAE leaving OPEC probably doesn’t change that fact. This is maybe a story for after we get past this disruption, but that will take some time.

Long-term, the demise of any cartel is good for consumers, right? Or is there anything more nuanced in this situation?

There’s a real question to what extent OPEC was really able to keep the price of oil elevated in recent years as the U.S. became a major producer. Guyana is now starting to produce oil in large amounts in South America—they are not a member of OPEC. Venezuela also seems to be ramping up after the recent changes there.

The price of oil is being shaped much more by the U.S. as a swing producer, and the price of oil is dictated by the economics of the shale patch: U.S. producers need $50 to $60 a barrel to produce. If they’re not getting that then they’re going to cut back, and that kind of dictates the global price of oil.

Also, the UAE was by some estimates producing above its quota even prior to the outbreak of hostilities.

One of the roles that OPEC does play is lowering the volatility of the price of oil, keeping it more predictable. If OPEC unravels then you could see much more volatility in energy prices. In general, that volatility is undesirable because everybody needs energy and we would like it to have a fairly predictable price.

The Iran war has accelerated a global pattern that was already underway—countries pulling into a defensive stance when it comes to energy. Lately the term “resource nationalism” has become a popular way to frame it. Is that how you see the paradigm shift happening right now?

I think it’s a fair term to describe what’s happening in energy markets, and there are a couple of threads that are tied together here. China has been taking steps for a while to try and reduce its vulnerability in terms of energy. That has taken the form of investing heavily in renewables and transitioning to electric vehicles since that lowers its dependence on oil. And they’re making efforts to build direct pipelines from Russia so they can secure oil that doesn’t have to be imported by sea.

Then there is what Europe is grappling with in the wake of Russia’s invasion of Ukraine. They’ve had to shift away from Russian natural gas very quickly, so they’ve doubled down on investing in renewables and tried to shift some of their liquefied natural gas imports to fill the hole from Russia. What Europe has already had to deal with [prior to the Iran war] has shown them their vulnerability.

Where does a shift toward resource nationalism leave the U.S.?

The U.S. has been much more forward-leaning in saying we have a lot of energy—we have oil, we have liquefied natural gas—and using that as leverage in negotiations, wanting to explicitly enter into bilateral agreements with countries to buy more U.S. oil and gas.

All of these threads are reinforcing the idea that countries need to take their energy security into their own hands and find a way to be self-sufficient. That’s probably going to have medium- and long-run ramifications for how countries trade with each other and for pushing more and more countries to rely on domestic sources of energy. Now the falling cost of electric vehicles and the falling cost of solar and wind make some of those domestic-only sources of energy more attractive.

The war has been described as kind of an implicit subsidy for electric cars and renewables, after the explicit subsidies—at least in the U.S.—have been removed.

But it’s also a subsidy for coal. Countries like China and India have a lot of coal. Countries are going to be saying, should I rely on the U.S. for liquified natural gas or on Qatar for liquified natural gas that has to pass through the Strait of Hormuz? Or should I double-down on coal which I can get from more locations? It’s a dirtier fuel but it’s in some sense more secure.

The reasons that resource nationalism is happening are intuitive. What is lost as everybody begins to guard their resources and put up these walls?

Well, it’s inefficient. It means that energy is going to be more expensive, and it’s inefficient in the sense that countries are now each trying to domestically restore their energy sufficiency. It’s one thing for big countries like China and the U.S. to do that, where we have wind and solar resources and plenty of domestic oil and natural gas. But it’s very hard for smaller countries.

Japan put a lot of money into nuclear after the 1970s oil shocks. It built one of the world’s largest nuclear fleets and then shut down much of it after Fukushima and is now grappling with the question, Do we restart that? Because you can invest in solar and wind in Japan and that will get you part of the way. But to really get to be independent of fossil fuels, they have to do something like nuclear and that’s a hard question for a country that suffered the ramifications of the Fukushima disaster.

And thinking about resources more broadly—things like rare earth metals, essential fertilizer components where we’re experiencing choke points—when everybody’s trading oil, perhaps they’re also trading other things. But now everybody’s just guarding what they’ve got.

It’s tremendously hard to be self-sufficient in everything. As our Minneapolis Fed colleagues have shown, there are huge gains from trade, and I think those gains are particularly notable in energy and in these key commodities. If you’re trying to be self-sufficient in those, that can be highly costly.