The Iran war produces a sea change in Fed policy expectations

The Federal Open Market Committee voted to keep monetary policy on hold last week as was widely anticipated amid uncertainty about oil prices since the conflict with Iran began. The interest rate projections of Fed officials that were released were unchanged from the December meeting: The median expectation is there will be one rate cut late this year. 

However, Fed chair Jerome Powell expressed concern about progress in lowering inflation at the press conference stating that “if you don’t see progress, you won’t see rate cuts.”  

This assessment impacted the Treasury bond market: Yields on the 10-year bond and the long bond rose to eight-month highs last week, while the yield on the two-year note was up by half a percentage point to 3.9 percent since the war began. This likely was a factor in President Trump’s decision on Monday to delay striking Iran’s power plants. 

How the Fed views oil shocks today is very different than during the first two shocks in the 1970s, when oil supply disruptions contributed to stagflation. Inflation had surged ahead of both oil price spikes as the global economy expanded rapidly, and the Fed boosted interest rates significantly, which led to severe recessions. 

Since then, the Fed’s approach has been to look through oil price spikes. During Iraq’s invasion of Kuwait in August 1990, for example, the Fed lowered interest rates as the economy slipped into recession, instead of focusing on the inflationary impact. The Fed was able to do so, because U.S. dependence on imported oil declined after President Ronald........

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