An Economy Already Under Pressure
The U.S. economy entered 2025 in a weaker position than many acknowledged. The prevailing consensus — that growth would broaden beyond generative AI capex, buoyed by tax incentives from the One Big Beautiful Bill Act and a recovery in consumption — has not materialized. The economy was already absorbing three adverse aggregate demand shocks: sharply reduced immigration, a significant slowdown in government spending growth, and a dramatic increase in the effective tariff rate, which climbed from roughly 2.5% last February to 12% by November. Consumption was supposed to recover as these effects faded, but that recovery simply hasn't unfolded.
Now a fourth shock has arrived: rising oil prices driven by geopolitical conflict. And the Federal Reserve, rather than preparing to cushion the blow, appears poised to repeat the same mistake it made a year ago.
The Fed's Misreading of Oil and Tariff Shocks
There is a well-documented, 140-year economic history — one that the San Francisco Fed itself has written about — showing that tariffs and commodity price spikes ultimately reduce demand and lower inflation in the intermediate term. Yet the Federal Reserve continues to treat these supply-side disruptions primarily as inflation risks.
A year ago, the Fed got the tariff story completely wrong, viewing tariff increases as inflationary when markets correctly priced them as deflationary for cyclical activity. Cyclical stocks plunged, the inflation breakeven curve inverted deeply — signaling that investors expected inflation to fall over time — and the economy slowed. The same pattern is repeating now. Oil prices are rising, cyclical stocks are falling, longer-term breakevens are declining rather than increasing, and yet the Fed persists in framing this as an inflation problem.
What the Fed chair should have communicated is straightforward: We stand ready to cushion the biggest risk from rising oil prices, which is the employment side of our mandate, not the inflation side. The recessions of 1973, 1980, and 2008 were all accompanied — and in part caused — by spikes in oil prices. The danger is not that oil makes consumer goods permanently more expensive; it's that oil shocks destroy demand, slow economic activity, and kill jobs. The Fed is making this situation worse by focusing on first-order price effects while ignoring how the economy actually works.
AI Is Already Biting Into the Labor Market
Layered on top of these macroeconomic headwinds is the accelerating impact of artificial intelligence on employment — a force the Fed seems equally unprepared to address.
The signs are already visible. The Atlanta Fed's wage tracker, which adjusts for compositional shifts in the labor force such as aging demographics, reveals a notable change in pattern. For roughly three years, wages in the lowest income quartile were decelerating fastest, largely a consequence of the immigration surge. But around mid-2024, this dynamic flipped. Now it is the highest income quartile where wages are falling most sharply — a pattern consistent with AI beginning to displace higher-skilled, higher-paid workers.
Sector-level data from S&P 500 companies reinforces this picture. The technology sector reduced its workforce by approximately 1.5% last year, yet operating margins expanded by 180 basis points and sales per employee surged nearly 17%. These companies are extracting genuine productivity gains from AI, which in turn allows them to shed their least productive workers. Some companies are even using AI as convenient cover for layoffs that are really driven by years of declining stock performance and margin pressure. But the underlying trend is real: AI-driven productivity is enabling companies to do more with fewer people.
The Fed's response to this dynamic has been perplexing. Rather than recognizing that AI-driven displacement is a labor market risk requiring accommodation, the chair suggested that AI data center buildout could cause inflation in the short run. Once again, the focus is on first-order effects — the spending on construction and energy — rather than the second-order consequences of what that AI infrastructure will actually do to employment once deployed.
Where the Opportunities Lie
Despite this challenging backdrop, several investment themes emerge from the confluence of supply shocks, policy shifts, and structural changes.
Industrials and domestic manufacturing. The relentless sequence of supply chain disruptions — from pandemic-era shortages to tariff escalations to geopolitical conflicts — makes an increasingly compelling case for onshoring manufacturing to the United States. For European companies and U.S. firms currently manufacturing overseas, each new supply shock reinforces the logic of domestic production. Paired with the tax incentives in pending legislation, a meaningful pullback of 10–12% in the S&P 500 — with cyclical sectors declining further — could create an attractive entry point for the industrial sector.
Banking and financial services. Federal regulators have initiated the comment period on reducing capital requirements for the banking system. This is part of a broader effort to effectively privatize portions of the Fed's balance sheet by loosening capital and liquidity requirements, allowing banks to re-enter private sector lending rather than ceding the entire market to the private credit industry. This deregulatory push requires no new legislation — it is purely a matter of regulatory policy — meaning it faces minimal political obstacles over the coming years. Bank return on equity stands to benefit significantly. The post-financial-crisis regulatory tightening, while understandable in its moment, has become excessive, and its unwinding represents a durable, multi-year tailwind for the sector.
Short-duration fixed income. The two-year to five-year portion of the Treasury curve looks attractive on the view that the Fed will ultimately be forced to ease later this year. The notion that the Fed might hike rates in this environment is implausible given the demand destruction already underway. Investors positioned in short-to-intermediate duration bonds stand to benefit when reality forces the Fed's hand.
Conclusion
The Federal Reserve finds itself at a familiar and dangerous crossroads. By fixating on the inflationary appearance of supply shocks — whether from tariffs, oil prices, or AI infrastructure spending — it risks ignoring the far more consequential demand destruction and labor market deterioration that these forces set in motion. History is clear: oil price spikes cause recessions not through inflation, but through the destruction of economic activity and employment. AI is compounding this risk by enabling rapid workforce reductions across high-wage sectors. The Fed's dual mandate demands attention to both prices and employment, and right now, the employment side of that mandate deserves far more urgency than it is receiving.