The Fed Faces an Iran Dilemma: Energy Inflation Rises, Slowdown Risks Loom
US Federal Reserve officials met this week with an increasingly uncertain policy outlook after the Iran war disrupted the flow of about a fifth of global oil supplies. The meeting's focus shifted to a key question: whether this energy shock risks more than suppressing growth, making inflation more persistent, or triggering the most difficult combination for a central bank—an economic slowdown amid rising prices.
With inflation still about one percentage point above its 2% target and potentially rising if the oil price surge persists, market participants believe the Fed is likely to adopt a cautious to hawkish tone. Some economists believe that previously unthinkable debates are gaining momentum, including whether the chance of a 2026 interest rate hike should be on the radar—though that scenario remains remote without a clear surge in inflation expectations.
At the same time, the Fed must weigh whether this shock will undermine economic resilience through tightening financial conditions, weakening asset prices, and increasing uncertainty. The risks mentioned include a weakening labor market—including a 92,000-job decline in February—as well as pressure on lower-middle-income consumers already squeezed by high prices and concerns about a credit crunch if the asset class decline continues.
The impact at the household level is already being felt. Average US retail gasoline prices have reportedly risen nearly 25% in the two weeks since the US and Israel launched attacks on Iran, reaching their highest level since October 2023. The US government estimates the conflict could end within weeks, with the US Energy Secretary saying supplies are likely to recover and prices to fall afterward, although the war's course remains difficult to chart due to the lack of clear targets and timelines.
The Fed's policy meeting on Tuesday-Wednesday is expected to keep interest rates unchanged. However, officials will still release updated economic projections—trying to assess whether tighter policy is needed to combat inflation, or whether room for rate cuts is needed to mitigate the slowdown. Complexity is heightened as the Fed is entering a leadership transition, with Kevin Warsh—President Donald Trump's nominee—expected to replace Jerome Powell after mid-May if confirmed by the Senate.
In the "fog of war" and high oil volatility, the easiest approach is to stick closely to previous projections, which indicated a median of only one rate cut this year. However, internal differences in views could become prominent, given that some officials have previously indicated a preference for higher interest rates, and the minutes of the January meeting left open the possibility of a hike if inflation remains above target.
The market will be monitoring the duration of the conflict and the recovery of flows in the Strait of Hormuz, the resilience of oil and gasoline prices, the direction of inflation expectations and Treasury yields, signs of credit tightening, and labor market dynamics—variables that will determine whether the Fed will remain hawkish for longer or reopen the easing space as growth risks intensify.
Source: Newsmaker.id
