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 Reagan’s action to abolish remaining price-controls on U.S.-produced energy in January 1981. 

The U.S. has recently become a net energy exporter as of 2019: The shale revolution has resulted in the U.S. becoming the world’s biggest oil producer. It is also now the world’s biggest exporter of natural gas. As a result, the U.S. economy is less vulnerable to oil supply disruptions than in the past, although it still feels the impact of higher energy prices.

So why is the Federal Open Market Committee hesitant to resume monetary easing amid a soft job market? The main reason is that the Fed does not want inflation expectations to rise. At his press conference, Powell acknowledged that the economy has been slammed by an unusual number of supply shocks in the past six years, and inflation has been consistently above the Fed’s 2 percent target. Some officials worry that the Fed’s credibility as an inflation fighter could be tarnished if it misses the target again because of the spike in oil prices. 

Federal Reserve governor Christopher Waller voted to keep rates unchanged at the March Fed meeting, after having voted to ease policy in previous meetings. In an interview with CNBC, Waller acknowledged, “It’s going to be a much more protracted conflict, and oil prices are going to stay high for a longer time.” The disruption of oil supplies is the largest in history, according to the International Energy Agency, as 20 percent of the world’s oil and natural gas pass through the Strait of Hormuz.  

Further evidence that the Fed’s stance may be changing was Chicago Fed President Austan Goolsbee’s assessment this week that the central bank might need to tighten monetary policy if rising oil prices boost inflation. The core rate for the Fed’s preferred measure of inflation, the personal consumption deflator, is close to 3 percent, and it could ebb higher. The price of diesel fuel soared past $5 a gallon last week for only the second time in history, and it will filter through the economy via higher transport costs.

Meanwhile, the Organization for Economic Cooperation and Development has raised its forecast of U.S. consumer price inflation to 4.2 percent this year from 2.6 percent last year as a result of higher energy prices.  

Amid this, Trump has continued to criticize the Fed for not lowering interest rates sufficiently. He is banking on his nominee for Fed chair, Kevin Warsh, sharing his vision that the economy can grow much faster without rekindling inflation.

Warsh wrote an op-ed for the Wall Street Journal in November that laid out his case for lower interest rates. He argued that the Fed should discard its forecast of mild stagflation, because “AI will be a significant disinflationary force, increasing productivity and bolstering U.S. competitiveness.” Since then, the Fed upped its projection of long-term potential growth from 1.8 percent to 2 percent in its March report. 

Should the Iranian conflict be unresolved when the Senate Banking Committee hearings to confirm his nomination are held, Warsh undoubtedly will be asked if his views have changed. If Warsh advocates for lower interest rates, he will have to forge a consensus among Fed members who currently are split on the issue. Meanwhile, the bond market is pricing in even odds that the Fed’s next policy move will be a rate hike or a rate cut.  

Nicholas Sargen, Ph.D. is an economic consultant and is affiliated with the Darden Business School.  The second edition of his book, “Global Shocks,” is forthcoming.

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