Oil-driven deflation

Substack Post Week March 23-27

The recent volatility across oil, gold, and rates has revived a familiar narrative: energy shocks as inflation catalysts. Yet a more consequential shift is taking place. Markets, and increasingly some policymakers, are beginning to recognize that the dominant risk is not inflation, but the amplification of already problematic economic and financial conditions. The oil shock could be just the accelerant of the instability, not the cause.

Start with markets. The sharp decline in oil prices on rumors of US–Iran talks briefly triggered a risk-on response, but the reaction was uneven. Equities rebounded, yet gold continued its liquidation, falling roughly 12% in a matter of days. This is not consistent with easing macro risks. Instead, it points to tightening monetary conditions and, of course, persistent demand for dollar liquidity. This distinction matters because it aligns with what we observe across the monetary system. Data from cross-border flows and balance sheet activity indicate that dollar liquidity had already been tightening well before the geopolitical shock. Banks were pulling back from offshore intermediation, while foreign holders were increasingly forced to sell reserve assets.

Against this backdrop, the real economy is beginning to show more visible cracks. The labor market, in particular, appears significantly weaker than headline indicators suggest. More comprehensive data sets point to persistent job losses that have been masked by statistical smoothing and/or lagging revisions. The implication is that labor demand has already moved closer to a critical threshold, what the Beveridge framework would describe as the “flat” region.