A Compounding Oil Shock: Part II
The Fed Playbook: Reaction Function and Decision Grid
Key takeaways:
A physical oil shock in a K-shaped economy can partially dampen its own inflation persistence through demand destruction. That matters for the Fed: a reflexive hawkish response could worsen the damage by adding tighter credit to an income squeeze that is already hitting the most exposed households.
Two market signals matter most here: the 10-year breakeven and the 2-year synthetic real yield. Together, they give a simple way to think about the Fed’s policy position. But once you account for the K-shaped nature of the economy, each scenario transmits differently from what the standard representative-agent framework would suggest.
Part III proposes what I call a “Supply Accord”: a coordinated fiscal-monetary response designed to address what the rate instrument cannot.
If Treasury cannot fix a physical oil shock, what exactly is the Fed supposed to do? Part I of this blog series established why the proposed Treasury operation fails: the right instrument for a financial shock is not the right instrument for a physical one. The same logic applies here. It defines the limits of what monetary policy can achieve as well.
Related Post:
A Compounding Oil Shock: Preface
A Compounding Oil Shock: Part I (Why the Treasury Cannot Short a Physical Shortage)
Background
From a central bank perspective, demand shocks are easier to deal with. When demand runs too hot, inflation rises, and the output gap is positive, the policy response is unambiguous. Tighten. When demand is too weak, inflation falls, and the gap turns negative: ease. No trade-off. Both objectives point in the same direction (“divine coincidence”).
A physical supply shock does the opposite. It raises inflation and weakens growth simultaneously, placing the central bank in a genuine dilemma: anchoring long-run inflation expectations calls for one response; supporting activity/employment calls for another. No rate level solves both problems at once. There is often no comfortable middle path: the choice is about which damage to prioritise.
It is tempting to read the current shock through the experience of 2022, when the Russia-Ukraine war fed directly into the inflation surge the Fed had to manage. But the comparison only goes so far. In 2022, the oil shock was also beyond the reach of the rate instrument, yet logistics could adjust over time. Alternative supply routes emerged, the initial disruption was partly absorbed, and oil prices eventually reversed. The Fed did not close that wedge. Geography and tanker arbitrage did.
The closure of the Hormuz chokepoint is different in kind. A strait cannot be rerouted. When roughly a quarter of global seaborne oil trade passes through a single narrow corridor, the constraint is geographic before it is economic. That changes the central bank’s problem in a fundamental way.
The rest of the piece sets out what that means for the Fed’s reaction function, the indicators worth watching, and the case for policy coordination.
From oil wedges to inflation: the transmission chain
The wedge decomposition from Part I matters for monetary policy, not just for commodity analysis. Each wedge feeds first into energy prices, then into headline CPI, and then into the non-energy sector, where the real question emerges: does the inflation shock fade, or does it start to stick? That transmission chain is what the Fed has to read. One further complication runs through it all: the K-shaped structure of the US economy changes both the speed and the force of the pass-through.
Step 1 — Wedge changes drive energy-price inflation
Changes in each of the four wedges flow directly into the price of energy reaching consumers. The energy-price inflation rate Δp_tᴱ, is the sum:
where Δp_tᴱ is the change in the price of energy, Δmc_tᴱ is the change in the marginal cost of energy production, Δτ_t represents changes in shipping and insurance costs, Δy_t captures the change in the convenience yield, and Δρ_tᵍᵉᵒ reflects changes in the geopolitical risk premium embedded in energy prices.
This is a price-level accounting identity, not a structural equation: any observed change in the energy price can be attributed to movements in one or more of the four wedges. That decomposition is the starting point for the policy analysis below.
The approximation assumes fixed basket weights (ωₑ) and negligible substitution over the relevant short-run horizon. In the US, ωₑ runs close to 6.4% (BLS CPI-U, 2024 vintage). That direct term can move headline inflation meaningfully, but it is not the core of the central bank problem. The real issue is what happens next in the non-energy sector, where broader inflation dynamics take hold.
Step 2 — The cost-push shock enters the Phillips curve
In the sticky-price non-energy sector, the oil shock enters as an exogenous cost-push disturbance u_tᵒⁱˡ. The sector’s New Keynesian Phillips curve (Aoki, 2001) is:
where x_t is the output gap, β is the discount factor, and κ is the slope of the Phillips curve (how sensitive inflation is to the output gap). Oil enters as a cost-push shock: when energy input costs rise, non-energy firms’ real marginal cost rises, and they eventually pass it through in prices.
The key point is simple: u_tᵒⁱˡ can remain positive even when x_t is negative. In other words, cost-push inflation can persist even as the economy weakens. That is the essence of stagflation, and it is what makes a supply shock different from an ordinary demand-management problem. The Fed can influence the output gap and, indirectly, inflation expectations. It cannot directly remove the oil shock itself.
The K-shaped economy: why this dilemma is not symmetric
The baseline New Keynesian framework is built on the representative-agent assumption. As a reference point, it is useful; as a description of the current US economy, it misses something critical. The economy is K-shaped (bifurcated between high-income asset owners and lower-income consumption-dependent households), and an oil shock hits those two groups in opposite directions. That matters for how monetary policy transmits.
This is not just a theoretical point. The NY Fed’s Economic Heterogeneity Indicators through December 2025 show that lower-income households have faced persistently higher inflation than higher-income households. Since 2023, real consumption growth has also diverged sharply, with stronger gains at the top and much weaker momentum among low- and middle-income households. The economy was already bifurcated before the oil shock arrived.
An oil price surge widens the gap further. It acts like a regressive transfer, taking real income from households for whom energy is a large share of spending and who have little buffer to absorb the hit. For higher-income households, the same price increase is usually a smaller adjustment. The aggregate effect is asymmetric:
This matters for inflation through two channels. First, the output gap deteriorates faster because lower-income households with high propensities to consume are forced to cut spending quickly. That makes the κx_t term more negative and offsets part of the oil shock. Second, weaker demand limits second-round effects. Firms facing a spending slowdown cannot pass rising costs through as easily, and workers in the most exposed sectors are more likely to face job insecurity than sustained wage leverage. In that environment, inflation expectations may stay anchored not only because the Fed is credible, but because the macro conditions for a wage-price spiral never fully develop.
None of this removes the dilemma. The oil shock still pushes inflation up and still has to be contained if it starts to spread. But it does change the timing. In a K-shaped economy, the output gap can deteriorate faster, and second-round inflation pressure can build more slowly. That gives the Fed more reason to watch carefully before tightening on reflex.
Step 3 — The wedges map into u_t with different pass-through speeds
The cost-push disturbance is itself a weighted sum of the four wedge changes:
The α coefficients are structural priors on pass-through speed: τ hits fast; ρ_geo reaches crude quickly but passes through to retail more slowly; Δy is sharp but reverses when inventories rebuild; Δmc is the most persistent, because disrupted physical infrastructure does not restart overnight.
So the identity of the dominant wedge matters not only for the size of the inflation shock, but for its likely persistence. And persistence is what matters for the Fed. A shock driven mainly by risk premia and shipping frictions looks very different from one increasingly driven by inventory scarcity or deeper production disruption. That distinction should shape the policy response.
What the Fed cannot control
Before asking what the Fed should do, it helps to be precise about what it cannot do. The Fed has one primary instrument: the path of short-term nominal interest rates, plus its balance sheet.
All four oil wedges feed into u_tᵒⁱˡ, and the Fed cannot neutralise any of them at source. What it can do is keep the forward expectations term β·E[π_{t+1}ᴺ] anchored. If it succeeds, u_tᵒⁱˡ passes through the price level once and fades. If it fails, firms and workers embed the higher price level into wage and price-setting, the transient shock becomes structural. That is the Burns error (see Christiano, L., & Gust, C. (2000). The expectations trap hypothesis.), and it is the main risk monetary policy is actually equipped to guard against.
There is also another channel the Fed has to watch: the oil shock can tighten financial conditions on its own.
The output gap x_t in the Phillips curve is not exogenous. It is determined in part by financial conditions. An oil spike triggers a sequence: equity markets reprice earnings and discount rates, credit spreads widen as corporate cash flows deteriorate, the dollar strengthens on safe-haven demand, which tightens financial conditions independently of any rate decision. This results in Δfci < 0. It compresses x_t directly, reinforcing the demand destruction already running through lower-income households.
The implication follows: in a financially integrated, K-shaped economy, the usual stagflation reflex can overstate the case for immediate tightening. The oil shock raises the cost-push term, but it also weakens the output gap through both household demand compression and tighter financial conditions.
Mapping into Market Observables
Each term in the Phillips curve can be matched to a market-based indicator. That makes it possible to monitor the policy problem in real time rather than discuss it only in theoretical terms.
The 10-year breakeven inflation rate (π₁₀^BE) — the long-run anchor
The 10-year breakeven is the closest market proxy for longer-run inflation expectations. As long as it remains near 2.3%, the Fed has some room to look through a near-term cost-push shock. If it drifts toward 2.6–2.8%, expectations may be starting to move. Beyond that, the risk is that markets stop treating the shock as temporary.
The 2-year synthetic real yield (r²ʸ) — constructed as the 2-year Treasury minus 2-year CPI inflation swap
This proxies the output-gap term κ·x_t. There is no liquid 2-year TIPS (Treasury Inflation-Protected Securities). The conventional approach, reading off the TIPS curve at the 2-year point, is not available here. The synthetic is constructed as: r²ʸ = US 2-year Treasury yield − US 2-year CPI inflation swap. This gives a market-based measure of the real rate at the 2-year horizon, using inflation swap pricing rather than a TIPS bond.
The interpretation is the following: when the synthetic real yield falls while nominal yields hold, the output gap is deteriorating, and demand destruction is running. When it rises, the rate instrument is biting, and the real economy is absorbing tighter policy.
The change in 1-year breakeven as a proxy for u_t shock
If the 10-year breakeven proxies β·E[π _{t+1}ᴺ], the 1-year breakeven could be used to measure the current-year size of u_tᵒiˡ, how much cost-push inflation the shock is injecting into the near-term price level. The shock-attributable component of u_t can be isolated as the change in the 1-year breakeven since the disruption onset: Δπ₁ ^BE = 3.41% − [Feb 20 pre-shock baseline] — the market’s implied estimate of the incremental near-term cost-push inflation injected by the Hormuz shock, stripping out the pre-existing inflation dynamics that were already priced before the disruption. The inverted term structure — 1-year breakeven at 3.41% versus 10-year at 2.38% — suggests the market is pricing a large near-term inflation hit that is expected to fade rather than become embedded. If the 1yr BE rises toward 4% or above, u_t is re-accelerating, and grid transition risk intensifies. If it falls back toward 3%, the shock is being absorbed.
Observable proxies for the Phillips curve terms
The table below links each market indicator to one term in the Phillips curve. The first five rows track the core inflation-growth configuration. The shaded final row captures the K-shaped signals that can change the policy reading.
The shaded row (income-disaggregated spending) is the primary K-shaped signal — tracked via the OI Economic Tracker (Affinity Solutions) and BofA Institute Consumer Checkpoint.
The Interest Rate Reaction Function
Taken together, the 10-year breakeven and the 2-year synthetic real yield define the Fed’s basic decision grid. On current pricing, the economy sits in Cell I.
The issue here is not fine calibration so much as sequencing. If the 10-year breakeven stays below 2.4%, the Fed has room to wait while weaker lower-income demand does some of the disinflationary work. If it moves above 2.6%, easing becomes much harder to justify. These are different states of the world, and they do not call for the same response.
Regime states: what wedge dominance means for the grid
The physical scenario determines which wedges are dominant, which in turn determines the size and persistence of u_t. The table below combines the three regimes, their wedge signatures, the nature of the cost-push shock, the market signals to watch, and policy implications.
The K-shaped risk is asymmetric — and it cuts against the standard hawkish prior
The key K-shaped risk is that the Fed waits too long to recognise that part of the disinflation is already coming from lower-income demand collapse. In that case, additional credit tightening would deepen the damage to the lower half of the distribution without delivering much extra inflation control.
The main signal to watch is income-disaggregated spending. If spending in the lower quartile is already slowing sharply, as tracked by the OI Economic Tracker or BofA Institute data, then the K-shaped demand channel is already active. In that case, the argument for patience becomes stronger: some of the disinflation may already be underway before the Fed has done anything.
In a physical supply shock, the rate instrument has a narrower role than usual. It must protect the inflation anchor, watch the K-shaped demand signals, and avoid tightening mechanically into a slowdown that is already doing some of the disinflationary work. That is a more disciplined response than the standard hawkish playbook. But it is still not enough. If the shock starts to become persistent, interest rates alone cannot carry the full adjustment.
Part III of this blog series introduces the Supply Accord: a coordinated fiscal-monetary arrangement aimed at the cost-push channels the rate tool cannot reach. It sets out Yield Anchor Operations, the conditions under which they activate, and why the design requires explicit Treasury–central bank coordination. Japan is examined as the clearest current case for the full framework.