US-Iran Conflict Clouds Fed’s Path on Interest Rates

The U.S. attack on Iran has complicated the Federal Reserve’s already challenging task of managing inflation and maintaining high employment.

Officials at the Fed are in the same boat as other forecasters: waiting to see how the outbreak of violence in the Middle East plays out, how long it lasts, and how severely it disrupts the U.S. economy.

The war has already caused energy prices to rise significantly, with WTI Crude up 8% since the conflict began as of Tuesday afternoon, and a gallon of regular gasoline up 10 cents to $3.11 per gallon, according to AAA.

The spike in energy prices has immediate implications for the Fed’s efforts to push inflation down to a 2% annual rate, especially if the war spreads or drags on for a long time. The war has disrupted oil exports from the Middle East, with more severe effects on U.S. energy prices the longer the conflict continues. On Wednesday, two Fed officials said they were watching the situation.

Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, said the war could have little impact on inflation, as in the Israel-Hamas conflict in 2023, or a more severe impact, as in the Russian invasion of Ukraine in 2022.

“That’s going to have effects on monetary policy,” Kashkari said, speaking at a Bloomberg event. “I don’t think anybody thinks when Russia invaded Ukraine and the inflation that resulted that the Fed should have just ignored that… It’s just too soon to know what imprint this has on inflation and for how long.”

John C. Williams, president of the New York Fed, said the effect on financial markets was “reasonably muted,” speaking at a separate event Tuesday. Williams did not address the war in prepared remarks, but spoke with reporters afterwards.

“We’ll have to see how persistent this is,” Williams said of the war’s effects on inflation, Bloomberg reported.

The war’s fresh uncertainty comes at a time when Fed officials are divided over whether inflation or labor-market weakness poses the greatest threat to the central bank’s dual mandate.

Prices rose 3% over the year, according to the Fed’s preferred consumer price measure, remaining consistently above the 2% target since 2021. Meanwhile, the job market is avoiding mass layoffs but adding a few jobs outside of health care.

“Inflation has been above the Fed’s objective for nearly five years now. I don’t think we have room to be complacent,” Jeffrey Schmid, president of the Kansas City Fed said at an event in Denver.

Schmid did not address the possible impact of the Iran war in his prepared remarks.

Williams, on the other hand, was more optimistic despite noting that tariffs have been pushing up consumer prices, keeping inflation stubbornly high.

“I anticipate inflation to start coming back down later this year when the peak effect of tariffs on the inflation rate is behind us,” he said, according to prepared remarks.

The Fed is widely predicted to resume cutting interest rates later in the year as inflation subsides, but the war could derail those expectations.

On Tuesday, traders dialed back their bets on Fed rate cuts: there was a 56% chance the Fed would keep rates on hold through June, up from 50% a week ago, according to the CME Group’s FedWatch tool, which forecasts rate movements based on fed funds futures trading data.