Oil prices surge = Hawkish Federal Reserve? Bank of America: The market may be misjudging, and the 2022 script is unlikely to repeat itself

Rising oil prices do not necessarily mean the Federal Reserve will turn hawkish. Bank of America Merrill Lynch warns that the market is misinterpreting the Fed’s policy response.

Since the outbreak of the Iran conflict, the 2-year U.S. Treasury yield has risen in tandem with oil prices, with the market directly pricing supply shocks as signals of monetary tightening.

According to the March 10 Morning Market Brief from BofA Merrill Lynch, this logic is fundamentally flawed: supply shocks threaten both ends of the Fed’s dual mandate, and the uncertainty of policy paths broadens in two directions rather than leaning solely hawkish.

Aditya Bhave, an American economist at BofA Merrill Lynch, points out that the current macro environment is very different from 2022—labor markets are soft, inflation is moderate, and fiscal stimulus is limited. If oil shocks persist, the Fed is more likely to adopt a dovish stance rather than repeat the aggressive rate hikes of 2022.

Market directly prices oil price increases as hawkish signals

Since the Iran conflict erupted, the 2-year U.S. Treasury yield has closely tracked WTI crude oil prices. The market’s implicit logic is: rising oil prices boost inflation expectations, forcing the Fed to keep interest rates high or even restart rate hikes. The only exception was the week after weak February non-farm payroll data, when yields briefly diverged from oil prices.

BofA Merrill Lynch believes this pricing approach ignores the dual nature of supply shocks. While supply shocks push up inflation, they also suppress economic growth and employment, creating conflicting pressures on the Fed’s dual mandate—price stability and maximum employment.

This tension causes the “tails” of policy distribution to thicken simultaneously: the probability of prolonging rate pauses increases, rate hike tail risks remain, but the risk of significant rate cuts cannot be ignored either.

Why the 2022 script is hard to replicate

BofA Merrill Lynch emphasizes that the premise for the right-tail policy risk (i.e., the Fed turning hawkish due to oil prices rising) is that economic demand remains strong enough to withstand supply shocks without significant slowdown, allowing the Fed to focus on inflation. In 2022, the Russia-Ukraine conflict met this condition: unemployment below 4%, core PCE inflation over 5%, average monthly non-farm job gains of about 500,000, and consumers holding substantial pandemic-era fiscal savings.

The current environment is starkly different. BofA Merrill Lynch notes that the labor market is soft, inflation is moderately high, and fiscal support is relatively limited. Under these conditions, if oil shocks are persistent, the Fed is more likely to adopt a dovish approach rather than tighten policy as market expectations suggest.

Policy uncertainty broadens on both ends

BofA Merrill Lynch’s core view is that rising oil prices “thicken the tails” of policy distribution rather than shifting probability mass solely toward hawkish outcomes. Specifically, the likelihood of prolonging rate pauses increases, rate hikes remain a tail risk, but if supply shocks continue to drag on growth, the risk of deep rate cuts also rises.

The current macro fundamentals mean the Fed’s sensitivity to oil shocks is very different from 2022. If markets continue to price based on the old script, they risk making directional errors.

On the macro data front, BofA Merrill Lynch has revised down its Q1 GDP tracking estimate from the previous 3.3% to 2.9% (seasonally adjusted annualized rate), mainly due to weaker-than-expected retail sales in January and non-farm payrolls in February. Personal consumption expenditure tracker fell from 2.2% to 1.8%, and residential investment from 1.5% to 1.0%.

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