Fed Officials Urge End to Rate-Cut Bias Amid Oil Price Shock from Iran Conflict

Federal Reserve officials dissenting from the recent policy statement have raised concerns about the implications of the escalating oil price crisis linked to the U.S.-backed conflict with Iran. They assert that the central bank must abandon its inclination towards interest rate cuts due to increasing uncertainty surrounding inflation and economic stability.

In a notably divided vote, the Federal Reserve maintained its benchmark overnight interest rate within the 3.50%-3.75% range, marking the most contentious decision since 1992. The Fed’s language hinted at a potential rate cut, continuing a trend initiated approximately 18 months ago aimed at reducing elevated borrowing costs that were implemented to combat inflation. However, inflation rates remain significantly above the Fed’s 2% target, prompting some policymakers to reconsider the feasibility of further rate reductions.

Cleveland Fed President Beth Hammack articulated the prevailing sentiment, stating, “Inflation pressures continue to be broad-based, and rising oil prices present an additional source of inflationary pressure.” Hammack, along with two other colleagues, supported the decision to keep rates steady but dissented due to the perceived “easing bias” in the policy statement. She emphasized that the current outlook no longer justifies such a bias.

Minneapolis Fed President Neel Kashkari highlighted the potential ramifications of a prolonged closure of the Strait of Hormuz, a critical artery for global energy supply. He warned that disruptions in this region could lead to a price shock significant enough to necessitate “potentially a series” of rate hikes to manage inflation expectations effectively. Kashkari noted, “The price shock wave could be much larger than is currently expected,” indicating that a robust policy response may be required, even at the risk of further labor market weakness.

The policy statement, which passed with an 8-4 vote, reiterated existing language that three voting Fed officials deemed inappropriate. The dissenting vote included a member advocating for a rate cut.

Market-Based Measures of Future Inflation Expectations Rise

The ongoing conflict has pushed global oil prices well above $100 per barrel, peaking at $126 recently, compared to $70 at the onset of the conflict two months ago. The average price of gasoline in the U.S. surged nearly 10 cents overnight to approximately $4.39 per gallon, a stark increase from around $3 in late February, according to the American Automobile Association (AAA).

Omair Sharif, president of Inflation Insights, noted that while it is still early in the assessment, the Fed may encounter a consumer price reading for May exceeding 4% ahead of its next meeting in June. This scenario mirrors the inflation surge following the COVID-19 pandemic and the 2022 Russian invasion of Ukraine.

Kevin Warsh, anticipated to gain Senate confirmation soon as the next Fed Chair, may face a challenging environment characterized by surging energy inflation that risks permeating the broader economy. Sharif remarked, “That is a tough environment from which to argue for rate cuts,” a stance that aligns with expectations set forth by former President Donald Trump.

While Fed officials maintain that inflation expectations are stable, surveys indicate a marked increase in households’ near-term inflation expectations since the onset of the conflict, with more modest increases in long-term outlooks. Market-based measures have also begun to reflect these shifts.

The inflation rate implied by yields on 10-year Treasury Inflation-Protected Securities (TIPS) has reached its highest level since 2023, climbing about 25 basis points since the conflict began. Similarly, the rate on 5-year TIPS has seen a comparable increase. The 5-year, 5-year forward rate, which measures expected inflation five years from now for the subsequent five years, has risen approximately 20 basis points since late February, nearing its highest level of the year.

During the post-meeting press conference, Fed Chair Jerome Powell acknowledged the fluid nature of inflation dynamics surrounding the conflict. He indicated that the consensus among Fed officials is shifting towards eliminating the easing bias in favor of more neutral language, potentially paving the way for a rate hike as early as the June 16-17 policy meeting.

In his recent statement, Kashkari pointed out another concern regarding the “easing” language. He suggested that even under a “benign scenario,” where the Strait of Hormuz reopens soon, underlying inflation in the U.S. could remain at 3% for the year—well above the central bank’s target and sufficient to warrant maintaining the policy rate for an extended period.

Source: www.zawya.com

Keep reading for the latest cybersecurity developments, threat intelligence and breaking updates from across the Middle East.