Iran war is testing how long the Fed can look past higher energy prices

WASHINGTON (TNND) — Renewed pressure on oil prices and uncertainty about what will come next in the war with Iran are creating challenges for the Federal Reserve and raising questions about how long it can continue looking past an energy shock that has already gone on for months without an adjustment to rates.

Central banks typically look through energy shocks instead of responding them on the assumption that prices will eventually normalize and raising rates would slow an economy already taking a hit from higher oil prices. But it is getting harder for the Fed to look through the shocks from the war with Iran, which has dragged into a seventh month with no clear path to a resolution.

Oil prices have dipped some from the highs of over $100 a barrel during the peak of the conflict but are still well above pre-war levels and surpassed $90 after renewed fighting this week. Prices have climbed since the war started due to traffic through the Strait of Hormuz grinding to a halt, mostly cutting off access to 20% of the world’s oil and natural gas supplies that travel through it.

The challenge for the Fed goes beyond how high energy prices have climbed to whether what started as a shock is becoming a more persistent source of inflation with how long they have been elevated.

Inflation has retreated significantly from the highs seen during the pandemic, but is still stubbornly above the Fed’s target of 2%. “Core” measures, which strip out volatile food and energy costs have also been firmer than expected for the first half of the year.

Energy prices aren’t the only thing putting pressure on inflation. The massive artificial intelligence build-out is also pushing up prices for skilled labor and computer chips that are used in a wide range of consumer goods. A renewed trade war with Canada risks higher costs for imported goods. Diesel prices that are nearing record highs could also lead to higher costs on even more consumer goods through higher costs to transport them.

The Fed has held off on raising rates so far this year as officials tried to parse what effects the president’s aggressive use of tariffs would have on inflation and how long the conflict with Iran would last. It is getting harder for some officials to justify their wait-and-see approach as the war drags on and oil prices stay high.

“Maybe it is our reality that uncertainty will continue, energy prices will continue higher, inflation will be more embedded in our economy,” said Mark Williams, a finance lecturer at Boston University’s Questrom School of Business and former bank examiner at the Fed. “So, the Fed has to do their job. They have to increase interest rates.”

Treasury Secretary Scott Bessent indicated this week that recent inflation data was evidence the Fed should stay on hold.

“It is my belief that we’ve seen a supply shock,” Bessent said during an appearance on CNBC. “Traditionally, you don’t raise into a supply shock unless you see second- or third-order effects, and we are seeing the core inflation has remained very, very restrained.”

But more Fed officials have been pushing for rate increases in recent months, with three dissenting on July’s continued pause in favor of an increase. Others have said they may soon follow suit if inflation data does not show signs of improvement.

Since taking over as chair, Warsh has restated the Fed’s commitment to getting inflation back to the target of 2% but has described the U.S. would get there and provided little forward policy guidance. His most revealing comments came during his first keynote speech in Jackson Hole last week, when he said that underlying trends in inflation had not meaningfully improved and that the central bank may need to raise rates to address it.

Warsh did not say whether he would support an increase at the Fed’s next meeting to be held Sept. 15-16 but said the central bank may have “work to do” if underlying inflation trends do not improve.

“We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed,” Warsh said. “Otherwise, we have work to do.”

Fed governor Michael Barr said on Tuesday that rates may need to go up unless new data shows price pressures are easing.

“If trends in the data give me some confidence that inflation is moderating on a path to 2%, then I think we can take a bit more time to assess our policy stance. However, if inflation appears not to be moderating sufficiently, then I think we should act decisively to raise rates,” Barr said. Markets saw the odds of a quarter-point rate hike increase after Warsh’s speech last week in Jackson Hole. Investors are pricing the chance of a hike at the FOMC’s next meeting later this month at around 66% as of Wednesday, according to CME FedWatch.

Pressure is also mounting in financial markets, with 10-year Treasury yields climbing to highs not seen since 2007. Other central banks have not been as patient as the United States, as the European Central Bank increased rates in June and is expected to do so again this week.

Officials will get another inflation report before they meet with the August consumer price index being released on Sept. 11, giving policymakers another piece of data on whether price pressures are spreading.

After more than five consecutive years of elevated inflation, there are mounting questions about whether the central bank needs to act to maintain its credibility on price stability. The concern is that letting an energy shock permeate through an economy already struggling to root out inflation could lead to companies and workers to treat higher prices as a lasting fixture in the economy.

“What they’re concerned about is the spiral effect of not doing anything,” Williams said. “The risk at this point of not doing anything is much greater than the risk of doing something.”