The Wall Street Journal | Middle East War + Inflation Breaking 3% Create Double Squeeze, Fed Faces "Policy Anchor" Reconstruction

Question AI · How does Middle Eastern conflict affect the Federal Reserve’s interest rate decision path?

The Fed Keeps Getting Hit With New Shocks in Its Yearlong Inflation Fight

A series of supply shocks have kept prices above target for five consecutive years. Now, policymakers must quantify how this situation will impact interest rates.

Jerome Powell’s term as Federal Reserve Chair ends in May

History is repeating itself.

This is the fifth year in a row that Fed officials, who initially expected inflation to fall back to the 2% target, have been disrupted by new shocks. It started with the aftermath of the pandemic, then Russia’s war in Ukraine, and last year, comprehensive tariff policies.

Latest data shows that inflation progress had already stalled before the Middle East conflict disrupted the world’s most important shipping lanes. This turmoil could push energy and commodity prices higher, further delaying the achievement of inflation targets.

Officials attending this week face a problem that seemed unlikely just a few months ago: the question is no longer when they will cut rates again, but whether they can still convince markets that rate cuts are on the table.

This war may reinforce the consensus to keep rates unchanged. A more complicated issue is what signals officials will send about policy directions in the months ahead. Three key points to watch:

First is the policy statement. In January, a few officials attempted to remove language hinting that the next move could be rate cuts, but were unsuccessful. If adjustments are made this time, it will mark the Fed’s first explicit acknowledgment that the easing cycle may be over.

Second is the quarterly economic projections. At that time, 19 participants will each outline their expectations for inflation and interest rates over the coming years.

Third is the post-meeting press conference, where Chair Jerome Powell can amplify or downplay any signals from the other two channels.

The impact of the war on energy markets makes the Fed’s job even more challenging.

In the short term, widespread uncertainty almost guarantees that the Fed will do nothing, just as last spring when officials remained on hold after tariffs were announced. Powell used the word “wait-and-see” 11 times at his May press conference last year.

But forecasts force officials to look ahead, and that’s where the outlook becomes more unsettling. The war has expanded the range of possible economic outcomes but hasn’t clarified which is most likely.

If the conflict is contained, oil prices could fall; if it escalates, oil could surge further, threatening higher inflation and weaker growth.

“Those who were more worried about inflation before will be even more worried now,” UBS Chief U.S. Economist Jonathan Pingle said. “But those more concerned about the labor market — which could increase their worries rather than ease them.”

When facing oil shocks, central banks’ standard advice is to ignore their effects, assuming the hit to growth and the boost to inflation roughly offset each other. But this advice relies on the public believing inflation will eventually come down.

After five years of inflation above target and a series of shocks constantly reminding consumers of rising prices, that trust is no longer a given.

“Do we really want to go through ‘Transient Inflation 2.0’ again?” Minneapolis Fed President Neel Kashkari said in an interview this month. In December, he expected only one rate cut this year.

Part of the problem is that the economy is experiencing multiple shocks whose effects are hard to disentangle. Besides tariffs and the looming oil crisis, tightening immigration policies have reduced labor supply, leading to a phenomenon: despite sluggish job growth, the unemployment rate has hardly risen.

Former Boston Fed President Eric Rosengren said that the inability to clarify each shock’s specific impact “makes it difficult for the Fed to make particularly decisive decisions.” Rosengren led the Boston Fed for 14 years, including during the 2008 oil crisis.

Interest rate forecasts are likely to dominate reactions at this week’s meeting. In December, 12 of 19 officials predicted at least one rate cut this year. It would take three of them changing their views to bring the median rate cut forecast down to zero.

This outcome would be interpreted as the Fed signaling a longer pause before raising rates again, though officials won’t coordinate these forecasts as they do with policy statements.

Markets have already repriced significantly. According to options prices from the Atlanta Fed, as of last weekend, traders see a 47% chance of at least one rate cut by December, down sharply from 74% before the Iran war outbreak last month. The probability of rate hikes before year-end has risen from 8% to 35%.

As the leadership transition approaches, risks intensify: Powell’s term as Chair ends in May, making any policy decisions this week a baseline framework for his successor to follow.

When officials raise inflation expectations, planning for rate cuts becomes more difficult, especially for those who believe current rates are near levels that neither stimulate nor restrain growth.

For policymakers expecting inflation to approach 3% by year-end, cutting from non-restrictive levels is hard to justify.

The Fed’s preferred core inflation measure — the core PCE price index, excluding volatile food and energy — accelerated to 3.1% in January. Last April, it was as low as 2.6%.

Jim Bullard, who served as St. Louis Fed President from 2008 to 2023, said he would have planned a rate cut at the end of last year but now would cancel that plan.

Given that core inflation remains above 3% and is rising, “you don’t want to commit to rate cuts right now,” said Bullard, now Dean of the Purdue University Business School.

Rosengren said that considering the shocks the economy is currently facing, the Fed’s current stance — implying that the next move is more likely to be rate cuts — has become harder to justify.

But for officials already uneasy about the labor market, describing it as fragile or vulnerable, this war should heighten their concerns. Up to three Fed officials might dissent this week in favor of rate cuts.

If anything, an oil shock that could squeeze household spending and curb consumption actually strengthens their case for keeping rate cuts on the table.

The current state of the U.S. economy is very different from four years ago when the Ukraine war pushed up commodity prices.

In 2022, employers added 377,000 jobs per month, and households had large savings buffers. Last year, job gains slowed to just 10,000 per month, loan default rates rose, and savings among the bottom 80% of income earners have shrunk significantly.

Pingle said the current situation is more similar to 1990, when the oil shock from the Gulf War pushed the economy into recession.

Regardless of what the forecast data shows, deeper changes may lie in whether the Fed can maintain its ability to anticipate potential risks.

For most of the past two years, when signs of labor market weakness appeared, officials cut rates — confident in their inflation outlook, they took preemptive measures against an impending recession.

Now, that logic may be breaking down.

“The Fed is leaning toward easing policy, that’s the big trend,” said Vincent Reinhart, a former senior Fed adviser now chief economist at Mellon Investment Corporation in New York. “But they won’t cut rates until they are sure inflation is heading lower.”

After last year’s rate cuts, many officials believed the current rate level’s restraining effect on the economy might be limited, and further cuts would be minimal if the economy remains resilient.

The worsening inflation outlook makes it even harder for them to use their remaining policy space. “Right now, they might just have to wait and respond to any economic softening,” Pingle said.

Published in: The Wall Street Journal

Author: Nick Timiraos, Chief Economics Correspondent in Washington

https://www.wsj.com/economy/central-banking/federal-reserve-inflation-iran-war-678d83ca

Translation: 24-Hour Observatory