How many rate cuts? Iran war upends Federal Reserve’s next steps

WASHINGTON (AP) — The Iran war has scrambled the Federal Reserve’s outlook on inflation and unemployment and will likely further delay interest rate cuts this year, putting off any relief for consumers struggling with high borrowing costs for home and car purchases.

The spike in oil and gas prices presents already-divided Fed officials with a worst-case scenario as they conclude a key meeting Wednesday: Costlier gas will raise inflation in the short run, which typically causes the central bank to raise borrowing costs — or at least leave them unchanged — to combat higher prices. Yet if the spike is high enough or lasts long enough, it could hammer the economy and push up unemployment, which the Fed would typically respond to by moving in the opposite direction, and cutting its key rate.

For now, the clearest way forward for the 12-member rate-setting committee, led by Chair Jerome Powell, is to stand pat and wait to see which way the economy goes. The Fed is expected to keep rates unchanged Wednesday, and may remain on pause at their meetings in late April and June. Many economists now see the first rate cut this year not taking place until September or later.

“With Iran and the oil shock, I think the committee’s room for maneuver here is pretty limited,” said Nathan Sheets, chief global economist at Citi and a former senior economist at the Fed. “I think they’ve got to wait and see how this plays through.”

Yet the Fed also has to release a set of quarterly economic projections that will create its own set of pitfalls. In December, the committee forecast that inflation would cool to 2.6% by the end of this year, with core inflation excluding food and energy falling to 2.5%. But those figures were already rising before the Iran war, with core prices rising 3.1% in January from a year earlier, the biggest increase in more than two years.

The Fed had also forecast in December that it would cut rates once this year, but that will be harder to maintain if the committee also raises its inflation outlook. The Fed cut three times last year before pausing in January.

Tim Duy, chief economist at SGH Macro, argues that the Fed should raise its forecast for core inflation, using the metric it prefers, to at least 2.8% by the end of this year. An increase of that amount would argue against any cuts this year.

“Any reasonable forecast for inflation now should not have a cut” in the Fed’s projections, Duy said. “And it’s almost ludicrous that it might.”

Whether the Fed will continue to forecast a single rate cut this year, or pull back and project no cuts, is seen as a close call by most economists. Many leading members of the Fed — including governors Chris Waller, Stephen Miran, Michelle Bowman, and possibly Powell — are reluctant to give up on the idea of reducing rates. Waller, for example, has said in a television interview that inflation is heading back to the Fed’s 2% target, with the Iran war likely only a temporary disruption.

Yet another group of Fed officials — including Beth Hammack, president of the Federal Reserve Bank of Cleveland, and Austan Goolsbee, president of the Chicago Fed — were already worried about the stubborn persistence of inflation even before the Iran war. The prospect of higher gas prices will likely only intensify their concerns.

Mortgage rates have already risen in the wake of the conflict, likely because markets expect higher inflation will prevent the Fed from cutting anytime soon. The average 30-year mortgage rate jumped to 6.1% last week from 6%, though it is still down from nearly 6.7% a year ago.

On top of all the economic disruptions, the Fed is nearing a major leadership transition. Powell’s term as chair ends May 15 and President Donald Trump has nominated a former top Fed official, Kevin Warsh, to replace him. Yet Warsh’s nomination has been delayed in the Senate because key Republican senators have objected to a Justice Department investigation of Powell over his testimony about a building renovation.

Last Friday, a judge threw out a pair of subpoenas that the Justice Department had issued to the Fed, dealing a blow to the investigation, but U.S. Attorney Jeannine Pirro has said she will appeal the ruling.

Also hanging over the Fed is the inflation spike from the pandemic. Typically, the Fed would essentially look past a supply shock like the disruption in oil supplies from the Middle East. Once it ends, any inflation it produces will likely fall back, without the Fed having to raise rates. As a result, it could leave rates unchanged — or even cut them to boost weak hiring.

Yet as the economy emerged from the pandemic in 2021, inflation jumped as Americans sharply raised their spending, aided by stimulus checks and pandemic-era savings. Powell initially said that inflation would be “transitory” and would fade as the economy returned to normal. Instead it spiked to a four-decade high in June 2022.

With inflation still elevated, many Fed officials are wary of repeating the mistake, making any cuts less likely as long as inflation is elevated.

“I think they are a little scarred from the blowback they got from the word ‘transitory,’” said Derek Tang, an economist at Macro Policy Analytics, a consulting firm.