Why Oil Shocks Hit The U.S. Economy Differently Than 20 Years Ago

[0:00] The US-Israel war with Iran has triggered the largest oil supply disruption in recent history. [0:05] Oil prices have been extremely volatile since this conflict began. [0:09] Analysts are tracking the reduction in oil output in the Gulf, speculating that a sustained supply [0:15] shock could push crude back toward triple-digit territory. Americans are already seeing this [0:20] pressure at the pump. The average price per gallon of unleaded gas in the US [0:25] surpassed $3.50 on Tuesday, the highest level since 2024. The last time the US entered a major [0:32] war in the Middle East was the 2003 war with Iraq, and oil prices climbed sharply in the years that [0:37] followed. But this economic moment isn't a carbon copy of the Iraq War era. Here's what, if anything, [0:44] the Iraq War can tell us about how the current conflict in Iran will impact the US economy. [0:49] Energy volatility is one of the earliest ways consumers feel the economic impacts [0:59] of any military action. [1:00] In the Gulf, during the years following the Iraq War, global oil prices rose sharply. [1:06] Oil climbed from around $30 per barrel in 2003 to more than $130 by mid-2008. [1:13] And by 2008, the national average for a gallon of gas had more than quadrupled from 2003 levels. [1:20] The war in Iran is going to remind a lot of people of past times that the United [1:25] States got involved in military conflicts and other kinds of conflicts that spiked [1:30] the price of oil. [1:30] But unlike 2003, the US is now the world's largest oil producer. That doesn't make the [1:55] US immune to global shocks. Oil is priced globally. But it does mean the macro impact is [2:00] one-sided than in past oil crises. [2:02] Oil prices affect inflation in two ways. First of all, there's just the direct price you pay at the [2:09] pump. When oil gets more expensive, you know, we make gasoline out of oil. And so when the price [2:14] of oil goes up, then gasoline gets more expensive. The second way is a little more indirect. When [2:20] oil gets more expensive, lots of other stuff gets more expensive in the economy. You know, if your [2:25] home is heated by oil, that gets a little more expensive. You know, if your business is heated [2:29] by oil and you sell oil, that gets a little more expensive. And if your business is heated by oil, [2:30] and you sell stuff, then that's a business cost for you. [2:34] Higher oil prices leading to inflation is only part of the story. Interest rates will also [2:39] directly affect household budgets. In 2003, the US economy was emerging from recession, [2:44] and inflation was low. The Federal Reserve's target interest rate was around 1%. [2:49] Over the past few years, inflation has remained above the Fed's 2% target, and interest rates are [2:54] still elevated compared with past environments post-financial crisis. That can change how markets [3:00] react to something like war-driven oil spikes. It's hard to compare the two wars, the Iraq war [3:07] in 2003 compared to what we're doing in Iran now. American economy was in a much different place [3:12] than it is now. Back then, we were coming out of a recession. We were coming out of the dot-com [3:18] bubble, the 9-11 attacks, and a stock market that was kind of taking a beating as well. [3:23] So we had very low inflation. In fact, the concern then was that inflation was too low and that [3:29] Federal Reserve officials were kind of trying to gin inflation up a little bit to where it [3:33] considered a healthy level that was congruent with a healthy economic growth. This time around, [3:39] we have stubbornly high inflation, we have high interest rates, and a very different economic [3:44] backdrop that's going to pose very different economic challenges. When people think about [3:49] interest rates, they mostly think about things like their mortgage, their car payment, [3:54] their credit card bills. Those are not interest rates that the Fed affects directly. Those are [3:59] interest rates that the Fed affects directly. Those are not interest rates that the Fed affects directly. [4:00] And they tend to follow something called the 10-year Treasury. [4:03] Since the conflict began, that benchmark yield has risen. This can have a significant impact [4:08] for the average American. Eleven percent of disposable income for the average U.S. household [4:13] goes toward required debt payments, including things like mortgages and credit cards. [4:18] Investors are looking out there and saying, we think there's going to be more inflation [4:22] because of this war. You know, the price of oil directly makes everything more expensive. [4:27] Investors also think that it is going to make the [4:29] Fed less likely to cut interest rates in the next couple of months under its current chair, [4:34] Jerome Powell. So those factors are keeping the Treasury yield relatively high. [4:39] One thing that we're not seeing, which is kind of curious, is that sometimes in moments of big [4:44] global chaos, you see investors buy up a lot of U.S. Treasuries, which pushes down their yields [4:50] because they're worried about the state of the world and nothing is safer than an investment [4:55] backed by the full faith and credit of the U.S. government. It speaks to a worry [4:59] people have that global investors are starting not to trust the U.S. government as a really safe [5:05] place to put their money because the deficit is very high, because debts are high, and also [5:09] because they have worries about the current president. The market's kind of in control here. [5:13] Its ability to influence things in these types of situations is a little bit constrained. Monetary [5:19] policy is not intended to deal with wars. Even if the Fed does cut here, that doesn't mean that [5:26] rates will come down. It doesn't mean that Treasury yields will come down. And we've [5:29] seen that within the market already, that there are very different, [5:33] very unique forces that come into play here that the Fed doesn't necessarily have control over. [5:39] Another factor with elevated Treasury yields is it will make servicing federal debt [5:43] more expensive. The Iraq and Afghanistan wars added trillions to the national debt over time [5:49] and widened deficits during the 2000s, which begs the question of how much a new conflict will cost. [5:56] This war will probably cost us something. It will probably affect the deficit. But [6:00] it's relatively small in the grand scheme of how much money the federal government spends. [6:04] The war is almost certain to add to the deficit. The way lawmakers in the White House approach war [6:09] costs is that they're separate and above general fund type of expenses. So you're not really [6:14] thinking about paying for these expenses with revenue or anything like that. They're sort of [6:18] a beast amongst themselves. On top of the cost for servicing the debt, [6:22] there's also what economists call opportunity cost. [6:25] Opportunity cost is just basically taking resources from one place and putting them [6:29] somewhere else. [6:30] So in this current instance, the opportunity cost would be where you could be focusing on [6:35] spending money on things that you want to get done domestically. Instead, you're taking those [6:40] resources and you're diverting them. And they're not just fiscal resources. There are intellectual [6:46] resources, those types of things that are diverting elsewhere now. So the agenda at home [6:51] takes a backseat. The agenda abroad comes to the forefront. And that's your opportunity cost.