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Economy · · 4 min read

Central Banks Are Leaning Against the Oil Shock, Not Ignoring It

The Fed held with two dissents for a hike, and the Bank of Canada raised rates. Both say the same thing about expensive energy, and it has implications for borrowers, savers and bond investors.

By the fnews.si editors

For most of the past fifteen years, the textbook answer to an oil price spike was that central banks should “look through” it. Energy shocks raise prices once, then fade. Raising interest rates in response mostly hurts growth without doing much about the cause. This week two of North America’s central banks showed that the textbook answer has a time limit, and that they think it has been reached.

What happened

The Federal Reserve held, but the vote was hawkish. On October 28 the Fed kept the federal funds target range at 3.75%–4.00%, where it has been since a quarter-point increase in September. The vote was 10–2. Both dissenters, Governor Lisa Cook and Cleveland Fed President Beth Hammack, wanted another quarter-point hike now. The statement upgraded its description of the economy to “expanding at a strong pace.” It said inflation “remains elevated” and added a blunt sentence: “The Committee will deliver price stability.”

The Bank of Canada hiked. On the same day it raised its policy rate by 25 basis points to 2.5%, its first move after holding at 2.25% for a year. The reasoning was unusually explicit. Inflation has run around 3% since April and is expected to reach about 3½% by year-end. Excluding gasoline, though, it was only 2.2% in September, and core measures are close to 2%. The Bank hiked anyway, to “reduce the risk that high energy prices spread” into everything else. It described energy prices as “higher-for-longer” and noted the Middle East conflict is in its eighth month with no clear resolution.

Why “looking through” stopped working

The look-through argument rests on one assumption: that people expect the price spike to be temporary. If households and businesses believe that, they don’t demand bigger raises or build higher prices into contracts, and the shock fades on its own.

That assumption gets weaker the longer the shock lasts. Oil has risen for four straight months. Brent is up more than $40 a barrel since the end of June. The Bank of Canada’s statement spells out the mechanism it fears. High fuel costs raise production and transport costs, and the Bank expects businesses to pass more of that on to customers over the next year. This is the “second-round effect” central banks worry about. It is where a one-time price jump turns into ongoing inflation.

The US picture adds another ingredient. US inflation was reported at 3.7% for September, and the Fed’s preferred core gauge was expected to come in above 3%. Inflation has now been above the 2% target for more than five years. A central bank that has missed its target for that long has less credibility to spend on patience.

The difference between the two moves

The two banks are not in the same position, and the contrast is instructive.

  • The US economy is running hot. The Fed describes strong growth, robust investment and steady unemployment. Higher rates there are aimed at an economy that can take them.
  • Canada’s is not. Unemployment has been around 6½% for months, the Bank sees “excess supply” (spare capacity), and it expects new US tariffs to slow growth this quarter. The Bank of Canada is hiking into a softer economy. That signals how seriously it takes the inflation-expectations risk, and it also means the bar for further hikes is higher. The Bank said it “could need” to raise rates again but would “proceed carefully.”

What it means for your money

  • Variable-rate borrowers (mortgages, lines of credit, HELOCs) feel these moves first. In Canada, prime rates typically follow the Bank of Canada within a day. The Fed’s December 8–9 meeting is now a live decision, not a formality. Futures markets were pricing a strong chance of another hike.
  • Savers get the other side. High-interest savings accounts, GICs and money-market funds have stopped falling and may tick up.
  • Bonds face a tug-of-war. Short-term yields follow the policy rate up. Longer-term yields depend on whether markets believe the hikes will work. A central bank seen as serious about inflation can actually keep long yields lower than one seen as behind the curve. (See why bond prices and yields move in opposite directions and the yield curve explained.)
  • Currencies respond to the gap between countries’ rates. The Bank of Canada’s hike narrows its gap with the Fed somewhat. Oil is also Canada’s largest export, which tends to support the loonie when crude is high.

What to watch next

  1. Bank of England, Thursday, November 5. It is the next major central bank to face the same energy dilemma.
  2. US jobs report, Friday, November 6. Consensus is weak, at about 55,000 jobs. A strong number would make a December Fed hike more likely. A weak one would sharpen the trade-off between inflation and jobs.
  3. US CPI, November 10. The key line is inflation excluding energy. If that stays tame, the second-round fear is not yet showing up in the data.
  4. The oil price itself. A diplomatic breakthrough in the Gulf would take pressure off every central bank at once. An escalation would do the opposite.

The common thread: central banks are no longer treating expensive energy as somebody else’s problem. Until oil comes down or core inflation proves it isn’t following, expect rate decisions to stay finely balanced.