WASHINGTON — The ongoing conflict involving Iran has created complications for Federal Reserve policymakers as they weigh decisions about interest rates and economic policy, potentially pushing back any reduction in borrowing costs that would benefit consumers seeking loans for homes and vehicles.
Rising fuel costs have created a challenging situation for Fed officials who are already split on policy direction as they wrap up their important policy meeting on Wednesday. Higher gasoline prices typically drive up inflation in the near term, which would normally prompt the central bank to maintain or increase interest rates to control price growth. However, if energy costs climb too high or remain elevated for an extended period, economic damage and rising joblessness could occur, which would typically lead the Fed to lower rates instead.
At this point, the most straightforward approach for the 12-person policy committee, under Chairman Jerome Powell’s leadership, appears to be maintaining current rates while monitoring economic developments. The central bank is anticipated to leave rates unchanged on Wednesday and may continue this approach through their late April and June gatherings. Economic analysts now predict the initial rate reduction of the year may not occur until September or beyond.
“With Iran and the oil shock, I think the committee’s room for maneuver here is pretty limited,” stated Nathan Sheets, Citi’s chief global economist and former Fed senior economist. “I think they’ve got to wait and see how this plays through.”
The Fed must also publish quarterly economic forecasts that present their own challenges. Last December, officials predicted inflation would decline to 2.6% by year’s end, with core inflation minus food and energy dropping to 2.5%. However, these numbers were already climbing before the Iran situation developed, with core prices increasing 3.1% in January compared to the previous year, marking the largest jump in over two years.
December forecasts also indicated one rate cut this year, but maintaining that projection becomes more difficult if the committee simultaneously increases its inflation predictions. The Fed implemented three cuts last year before stopping in January.
SGH Macro’s chief economist Tim Duy believes the Fed should increase its core inflation forecast, using their preferred measurement, to at least 2.8% by year-end. Such an adjustment would argue against any reductions this year.
“Any reasonable forecast for inflation now should not have a cut” in the Fed’s projections, Duy explained. “And it’s almost ludicrous that it might.”
Most economists view the decision of whether to maintain the single rate cut forecast or eliminate it entirely as uncertain. Several prominent Fed members — including governors Chris Waller, Stephen Miran, Michelle Bowman, and potentially Powell — are hesitant to abandon rate reduction possibilities. Waller recently stated in a television appearance that inflation is moving toward the Fed’s 2% goal, with the Iran conflict likely representing only a short-term disruption.
However, another faction of Fed officials — including Cleveland Federal Reserve Bank President Beth Hammack and Chicago Fed President Austan Goolsbee — were already concerned about inflation’s persistence before the Iran conflict began. The possibility of increased fuel costs will likely heighten their worries.
Home loan rates have already increased following the conflict, probably because markets anticipate higher inflation will prevent Fed cuts in the near future. The typical 30-year mortgage rate rose to 6.1% last week from 6%, though it remains below the nearly 6.7% level from a year ago.
Beyond economic disruptions, the Fed faces a significant leadership change. Powell’s chairmanship concludes May 15, and President Donald Trump has selected former top Fed official Kevin Warsh as his replacement. Warsh’s confirmation has been delayed in the Senate due to Republican senators’ objections to a Justice Department probe of Powell regarding his testimony about a building renovation.
Last Friday, a judge dismissed two Justice Department subpoenas issued to the Fed, weakening the investigation, though U.S. Attorney Jeannine Pirro announced plans to appeal the decision.
The Fed also faces pressure from pandemic-era inflation experiences. Normally, the central bank would essentially ignore supply disruptions like Middle Eastern oil supply interruptions. Once resolved, resulting inflation typically subsides without requiring rate increases, allowing the Fed to maintain or even reduce rates to support employment.
However, as the economy recovered from the pandemic in 2021, inflation surged as Americans dramatically increased spending, supported by stimulus payments and pandemic savings. Powell initially characterized inflation as “transitory” and expected it to diminish as normalcy returned. Instead, it reached a four-decade peak in June 2022.
With inflation remaining high, many Fed officials are cautious about repeating past errors, making cuts less probable while inflation stays elevated.
“I think they are a little scarred from the blowback they got from the word ‘transitory,’” observed Derek Tang, an economist at consulting firm Macro Policy Analytics.
