A Compounding Oil Shock: Part III

The Supply Accord — A Policy Proposal

Figure: The Supply Accord — division of labor under a physical supply shock

Related posts:

A Compounding Oil Shock: Preface

A Compounding Oil Shock: Part I (Why the Treasury Cannot Short a Physical Shortage)

A Compounding Oil Shock: Part II (The Fed Playbook: Reaction Function and Decision Grid)

Part II showed what the Fed’s rate instrument can and cannot do under a physical supply shock. It can protect the inflation anchor. It can also monitor the K-shaped signals in the real economy and avoid tightening mechanically into the demand destruction that is already underway.

But it is not enough once the shock moves from transitory into persistent, and supply disruptions become structural. In this sense, the current situation differs materially from the Covid-19 one. With Covid, the supply constraint was self-imposed: governments closed economies, and once they reopened, production capacity came back. Here, the disruption is the product of targeted military action against critical energy infrastructure. This type of damage does not automatically reverse even if the Strait of Hormuz is reopened. Production capacity in the Middle East for crude oil, LNG, and other critical commodity inputs could remain severely impaired for an extended period.

As long as the dominant wedge is geopolitical risk, the shock can, in principle, reverse with de-escalation or an easing of market fear. But what is currently developing is no longer only an oil-price story. The disruption is propagating through shipping insurance, tanker routing, LNG availability, and fertilizer trade. In other words, the constraint is no longer only the price of energy but the capacity of the economy to move essential inputs through stressed networks.

What could happen next is that, as cost-push pressure rises and growth weakens, any fiscal response large enough to cushion the shock is likely to push up market rates unless something offsets that tightening. Plainly speaking, the state may need to cushion the shock, but the act of doing so can itself tighten financial conditions.

That is where a coordinated response becomes necessary. I refer to it as the “Supply Accord”: a fiscal-monetary configuration in which each instrument is assigned to the part of the problem it can actually affect. Fiscal policy works on the cost shock directly, through subsidies, transfers, reserve releases, and targeted support to downstream essentials. Monetary policy does something narrower but essential: it keeps the inflation anchor intact and prevents the fiscal response from being neutralized by a rise in term premia and an unnecessary tightening in financial conditions. The aim is not to suppress the market signal; it is to stop a physical supply shock from turning into a second policy-induced tightening shock.

In practical terms, the accord has three phases.

• First, fiscal policy absorbs part of the pass-through that the rate instrument cannot reach.

• Second, the policy rate remains focused on protecting longer-run inflation expectations.

• Third, if fiscal financing and market stress push up yields at the part of the curve where the government is issuing, the central bank leans against that tightening through targeted balance-sheet operations.

The commitment device that separates this from accommodation is a public exit rule tied to a forward inflation signal.

Yield Anchor Operations: Four Elements

The coordinated response works as follows. Fiscal policy targets the dominant cost-push wedge as the energy shock propagates to the economy. Monetary policy provides what I call Yield Anchor Operations, or YAOs: targeted balance-sheet actions that keep fiscal support from being offset by higher market rates while the policy rate remains on hold.

None of this is about stimulating demand. The objective is to stop a physical shortage from turning into a financial tightening and then into a distributional problem. The design has four elements. At their core is a single question: where is financing pressure showing up, and how can the central bank stop that pressure from undoing the fiscal response without affecting the inflation signal?

The first is the instrument itself. The central bank purchases at the segment of the curve where fiscal issuance and shock-related tightening are actually putting pressure on funding conditions. This is not a fixed-maturity intervention. It is a targeted operation at the point where tightening is occurring.

The second is maturity and coordination. Because the pressure point depends on how the fiscal response is financed, the target segment follows the maturity profile of Treasury issuance. In other words, if the Treasury has to fund the shock at the very part of the curve markets are selling, that is the part the central bank may need to stabilize. Explicit Treasury–central bank coordination on maturity profile is therefore likely to be necessary in practice: not over the inflation target or the stance of rates, but over how to stop the fiscal response from being undermined by the way it is financed.

The third is the trigger. YAOs are not a standing facility. They begin only when the yield pressure at the relevant segment looks more like a financing problem than an inflation signal. In practice, that distinction is hard to read cleanly. The term premium is not directly observable; it must be inferred from yield-curve decompositions that vary across models and are revised over time. The trigger, therefore, requires judgment and the observation of different indicators: a sustained rise in yields at the segment where issuance is concentrated, accompanied by widening credit spreads and risk-aversion indicators, while the 5-year 5-year forward remains within a range consistent with the inflation anchor. The call requires judgment, which is why the exit rule must be pre-committed and public. Without a hard exit condition, the trigger discretion becomes accommodation.

The fourth is exit. Operations stop if the 5-year 5-year forward inflation swap rate leaves the comfortable range, because that would indicate the inflation anchor is no longer secure. Similarly, the operation would stop when the underlying supply problem begins to heal.

Lastly, there is one important constraint: the long end of the yield curve should not be purchased. This is because that is where the 5-year 5-year inflation swap rate (the exit signal) stays. If the central bank buys at the long end, it distorts the signal it is relying on to credibly end the operation. This could be a real problem if the Treasury decides to fund the fiscal response by issuing at long maturities. In that case, the crowding-out pressure falls exactly where the central bank cannot act. To avoid this, the Treasury keeps its issuance concentrated at short and medium maturities during the life of the accord. That is another reason why coordination between the Treasury and the central bank is not optional (see point 2): it is structural. Without it, this structure faces a contradiction.

Why this is not accommodation

The obvious objection is that this looks like covert accommodation, or another version of debt monetisation. It is not. The central bank is not buying duration to cheapen fiscal deficits in general, and it is not trying to pin the long end in order to validate an inflationary fiscal stance. It acts only where fiscal issuance and shock-induced tightening are pushing market rates above what is needed to preserve the anchor. This is the key distinction. Indeed, the central bank can stop expectations from drifting. It cannot pump oil, move LNG cargoes, or reopen a strait. If the forward inflation signal remains inside the comfortable range, the bind is not de-anchoring. It is that the fiscal response is being offset by a second tightening shock coming from bond markets. If the forward signal moves outside the band, the operation stops. That exit rule is what separates a temporary anti-crowding-out operation from unconditional accommodation.

The three-phase escalation logic

In what follows, I lay out how the logic of the Supply Accord changes conditional on the evolution of the wedges discussed in Part I. The table below maps each phase to possible fiscal actions, monetary response, and the wedge being targeted.

Recall from part I that the spot price of oil is the sum of four components:

\(P = MC + \tau + y(I) + \rho_{\\{geo}}\)

where MC is the marginal cost of production; τ is the shipping and insurance cost; y(I) is the convenience yield — the premium the market assigns to physical possession of oil when inventories are critically low, and delivery is uncertain; and ρ_geo is the geopolitical risk premium, the market’s forward-looking assessment of the probability and duration of supply disruption.

This is where the story stops being about oil alone. As the shock moves downstream, the policy mix has to move with it: from cushioning retail energy costs to protecting the wider supply network.

In the first phase, covering roughly the first one to four weeks after shock onset, the dominant wedges are shipping and insurance costs together with geopolitical risk premia passing into retail energy prices. Fiscal policy in that phase is narrow and immediate: gasoline tax suspensions, temporary energy subsidies, and direct transfers to households most exposed to the rise in fuel and utility bills. Monetary policy holds. There is no balance-sheet action at this stage. The central bank’s job is to communicate patience while assessing whether the shock is fading or broadening.

In the second phase — roughly weeks four to twelve — the problem changes. The shock moves toward downstream inputs. Food, fertilizer, industrial energy, and broader cost-of-living pressures enter the picture. At that point, fiscal policy broadens as well, with support extending beyond utilities to downstream essentials. This is the phase in which YAOs would begin. Their purpose is twofold: to prevent fiscal issuance from pushing yields higher, and to lean against the tightening in financial conditions the shock is now creating. Balance-sheet normalisation is paused, but not reversed. The policy rate remains on hold.

At the structural phase, supply itself has become impaired, and the fiscal task shifts accordingly. For energy-importing economies, this means sovereign procurement of alternative LNG and energy supply, state-backed fertilizer purchases to prevent agricultural disruption, and administered energy prices for critical industries. For the US, where the energy supply threat is not as severe, the focus falls more narrowly on agricultural input costs, SPR management, and preventing downstream price effects on food and industry. In both cases, the fiscal commitment at this stage is larger, longer-dated, and harder to unwind than in earlier phases, highlighting both the risk of fiscal dominance and the importance of the exit rule. The central bank’s balance sheet is reoriented toward shorter maturities, anchoring short- to medium-term funding costs while leaving the long end free to carry the inflation signal. The policy rate remains on hold.

What makes the Supply Accord different from yield curve control

The 1942–1951 Fed-Treasury Accord pegged yields permanently to finance wartime debt, eventually producing the inflation that the 1951 Accord was designed to end. The Supply Accord inverts the logic. The purpose is not to finance the state at a protected rate. It is to stop emergency fiscal support from being neutralised while the physical shock persists. The yield anchor is therefore conditional and explicitly temporary: it exists only to prevent fiscal crowding-out during the duration of the shock. The moment y(I) normalises and MC wedge pressure fades, the balance sheet operation ends and normalisation resumes.

The commitment device is the 5-year 5-year forward inflation swap rate. As long as it remains inside an anchor-consistent guardrail, the operation should be read as anti-crowding-out rather than accommodation. If it moves outside that range, the presumption flips, and the operation ends.

Japan: the extreme case and the template

Japan is the clearest live test of this framework because all three vulnerabilities arrive at once. Its energy dependence on the Middle East is structural. LNG scarcity spreads the shock beyond crude. And the yen does little to mitigate the shock but rather amplifies it, raising the local-currency cost of every barrel and every cargo.

That makes Japan unusually vulnerable to a shock that travels from oil into utilities, fertilizer, food, and broader household costs. The initial response already fits the first layer of the Accord: measures aimed at gasoline prices and utility bills work directly on the retail pass-through from shipping costs and geopolitical premia. But if the shock persists, the fiscal problem broadens rapidly. What begins as energy support becomes support for food and other downstream essentials, because LNG scarcity feeds fertilizer costs and fertilizer feeds food inflation with a lag.

That is where the monetary side of the Accord becomes relevant. A Bank of Japan that pauses normalisation and leans against a disorderly rise in short- to medium-term funding costs is not trying to reflate demand. It is trying to stop the fiscal response from being offset by another tightening shock. Japan is, therefore, not just an example; it is the cleanest compressed version of the whole problem: energy exposure, food exposure, and currency exposure arriving at once, with very little buffer.

Corollaries

The K-shaped corollary

The K-shaped structure of the US economy changes how the fiscal side of the Accord should work in practice. Under this kind of shock, fiscal support is most effective when directed at households with the highest marginal propensity to consume, the lower-income households absorbing the largest share of the oil-income squeeze. Those households are already doing some of the disinflationary work through forced demand compression. The fiscal arm of the Accord should reinforce that stabilisation logic by targeting relief where the squeeze is most binding, rather than by delivering untargeted stimulus to households whose spending has not materially changed. The distributional question is not separate from the stabilisation problem.

The Supply Accord corollary

More broadly, the Accord clarifies the division of labour under a supply shock. The rate instrument protects the anchor. Fiscal policy absorbs part of the cost shock directly. YAOs stop that fiscal response from being undone by higher term premia and tighter financial conditions at exactly the moment support is most needed.

Conclusion

The Supply Accord is a proposal for a particular class of shock, not a template for routine macro management. It becomes relevant only if the shock stops looking like a temporary geopolitical premium and starts looking like a true structural scarcity problem, with inventory pressure and supply impairment moving downstream into food, fertilizer, and industrial inputs. If that is where the current shock is heading, the rate instrument alone will not be enough. In that regime, coordination will not be optional. The real question is whether it arrives early, with rules and boundaries, or late, after scarcity has already become inflation, financial tightening, and political stress.