Oil price surge due to Iran tensions adds challenges to Fed's interest rate reduction strategy

Iran Tensions Cloud Fed Rate Cut Outlook

Rising hostilities involving Iran have led many investors to question whether the Federal Reserve will move forward with interest rate reductions this year.

While there hasn't been a dramatic shift in expectations, the CME Group’s FedWatch tool—based on futures market data—still indicates a 76% chance that the Fed will lower rates at least once before year-end.

However, market participants are increasingly expecting any rate cuts to be postponed. The central bank is likely to wait and assess whether the recent spike in oil prices is a short-term event or signals more lasting economic effects. Instead of a June cut, more traders now anticipate the Fed will hold off until September, and some are even preparing for the possibility that rates remain unchanged throughout the year.

According to Richard de Chazal, a macro analyst at William Blair, “Any hoped-for rate cuts are, for the moment, off the table.”

He notes that oil price surges are often brief, but the Fed may still adopt a more cautious stance at its upcoming meeting while it waits for clearer evidence.

Inflation continues to exceed the Fed’s 2% goal, which has already made some policymakers wary of further rate reductions after last year’s cuts.

Data from the Bureau of Labor Statistics shows that the consumer price index increased by 2.4% in February compared to a year earlier. Although this is a significant drop from the nearly 9% peak in June 2022—when pandemic supply disruptions and the war in Ukraine drove inflation to multi-decade highs—there are concerns that inflation could accelerate again if oil prices remain elevated.

Thierry Wizman, a strategist at Macquarie, warns that persistent high energy costs could push up prices for a range of goods, including metals and food, as production and transportation become more expensive.

Wizman explains, “Energy price shocks ripple through production costs in almost every sector worldwide.” He emphasizes that central bankers are likely recalling the pattern seen from 2020 to 2024 as they consider their next moves.

Arguments for a Less Aggressive Fed

Some experts are less concerned about inflationary pressures.

Aditya Bhave, an economist at Bank of America, suggests that markets are still influenced by the events of 2022, leading investors to wrongly anticipate a more hawkish Fed this year.

Bhave points out that the economic environment in 2022 was very different: following the Ukraine invasion, the Fed raised rates aggressively, but at that time, unemployment was below 4%, inflation was already above 5%, job growth was strong after the pandemic, and consumers had extra cash from government stimulus.

This robust demand allowed the Fed to focus on bringing inflation back to target without causing significant harm to the economy.

In contrast, Bhave now sees a softer job market, moderate inflation, and less fiscal support, which could prompt a more accommodative Fed response if oil prices remain high.

Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics, argues that the current labor market is too weak for higher oil prices to trigger sustained inflation. Recent jobs data shows the U.S. added an average of just 17,000 jobs per month over the past quarter.

If energy costs stay high, consumers may reduce spending, and businesses that rely heavily on energy could become more cautious, potentially slowing hiring and economic growth in the coming months.

Tombs predicts, “We think the weakening labor market will be the FOMC’s main worry by the summer,” which could lead the Fed to implement three rate cuts this year, similar to its actions in 2024 and 2025.

Fed Likely to Remain Cautious

Despite the uncertainty, the Fed may avoid sending any clear signals at its upcoming meeting.

Chair Jerome Powell, whose term concludes in May, is scheduled to hold a press conference on Wednesday. He will likely face questions about the differing views among the Fed’s 19 committee members, each of whom will also release updated economic forecasts, including their outlook on potential rate cuts this year.

Derek Tang, CEO of Monetary Policy Analytics, believes it is too early to predict when—or even if—the Fed will ease policy after March, though he expects a single cut in June.

According to Tang, the Fed’s standard approach is to look past the inflationary effects of temporary energy shocks, which is why officials often focus on core inflation measures that exclude volatile food and energy prices.

However, Tang notes that the Fed’s willingness to overlook supply shocks has diminished after the prolonged struggle to bring inflation back to 2% following 2022.

He also highlights key differences from 2022: back then, the Fed’s benchmark rate was near zero, requiring aggressive hikes. Today, rates are much higher, between 3.5% and 3.75%. As a result, policymakers are likely to be cautious about further changes for now.

Matthew Raskin, a strategist at Deutsche Bank, expects the Fed to move slowly with additional cuts as long as labor market risks remain contained and employment stays steady.

He adds, “But if the conflict ends quickly and oil prices fall back, markets may once again expect some Fed easing this year.”