Why the Oil Shock Didn’t Cause a Recession

The 2026 war in Iran has reminded us how fast oil prices can move and how long they can stay elevated. After Tehran closed the Strait of Hormuz in early March, stranding a significant share of the world’s oil and gas exports, Brent crude rose from about $70 a barrel at the end of February to $138 in early April. A summer ceasefire brought it back to $70. But the reopening has stalled, and by late August Brent had climbed again to about $95. This is a classic oil supply shock, and it raises an old question: must such a shock end in recession?

Textbook Oil Shocks

The textbook answer is that it usually does, for at least two reasons. The first runs through firms’ reactions. Oil is an input to production, so a higher price raises firms’ costs, cuts output, and lifts prices. This is the uncomfortable mix of stagnation and inflation that gives stagflation its name. The second runs through household spending. As the energy bill eats up more of the household budget, families have less to spend on everything else, and those who cannot borrow spend less to soften the blow.

The Role of Central Banks

But this account is incomplete, and the missing part is substantial. Economists have long suspected that what matters is not just the shock itself but how the central bank responds to it. As oil prices rise, inflation and expectations follow, prompting the central bank to raise its policy rate. The real (inflation-adjusted) interest rate rises, forcing spending to fall. According to this interpretation, much of America’s long history of recessions following oil price spikes reflects monetary policy responses, not the direct effects of oil price changes.

The Zero Lower Bound

This points to a stranger possibility. Suppose the central bank does not raise its interest rate, because, for example, it sits at the Zero Lower Bound (ZLB) on the short-term nominal interest rate, the floor below which ordinary monetary policy cannot go. Inflation expectations still rise, but the nominal interest rate is stuck, so that the real interest rate falls instead of increasing. Lower real rates stimulate household spending. The same shock that weakens the economy in normal times can now be neutral, or even expansionary.

Our Research Study

In recent research, Wataru Miyamoto of the University of Hong Kong, Thuy Lan Nguyen of the Federal Reserve Bank of San Francisco, and I put that idea to the test. We compared ZLB periods with normal ones in Japan, the United Kingdom, and the United States from 1975 to 2019. We identified oil shocks using changes in oil-futures prices around OPEC announcements about oil supply. The responses differ not just in size but in sign. In Japan, a shock increasing the oil price by 10% lifts industrial production by about 1% a year later when rates are at the ZLB, but reduces it by more than 1% in normal times. In the United States, the figures run from +0.8% to −0.9%. The reason shows up in the data. At the ZLB, nominal rates barely move while expectations rise, so the real rate falls. In normal times, the real rate increases instead.

The Current Situation

This brings us back to the present. Unlike the episodes in our sample, the major central banks are no longer at the zero lower bound. As of August 2026, the Fed's target range is 3.50–3.75%, the Bank of England's rate is 3.75%, and the ECB's deposit rate is 2.25%. They sit in the normal regime, where central banks are free to change their interest rates in any direction. For now, only the ECB has increased its rate from 2% to 2.25%. Our findings suggest that central bank choices, more than the shock itself, will decide how costly the recent oil shock proves. By holding rather than hiking, they would lean toward the milder outcome. If they change course, as each has hinted, they would risk tilting their economies towards recession.