Oil Shock From Iran Conflict Complicates Fed's Rate Cut Plans

The Iran conflict is making investors more doubtful that the Federal Reserve will cut interest rates this year.

It is far from a wholesale repricing. Traders still see a 76% probability that the Fed will lower interest rates again this year, according to the CME Group’s FedWatch tool, which uses futures market pricing to gauge Fed policy views.

But investors are anticipating a delay in any Fed cuts, as the central bank waits to see whether the oil price shock will prove temporary or have lasting consequences. Instead of a rate cut in June, more traders are anticipating the Fed to wait until September. And some are preparing for the possibility that the Fed will keep rates flat all year.

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

Oil price spikes are typically temporary, he wrote, but the Fed may nonetheless adopt a hawkish tone at its meeting next week as it waits for evidence that’ll prove true.

Inflation remains above the Fed’s 2% target, a fact already making some Fed officials hesitant to follow up on its rate cuts from last year.

The consumer price index rose by 2.4% in February compared to last year, according to the latest Bureau of Labor Statistics data. It’s down from its recent peak of about 9% in June 2022, when pandemic-era supply chain pressures collided with Russia’s invasion of Ukraine, leading to decades-high inflation.

But it’s at risk of surging again if oil prices stay high, wrote Thierry Wizman, a strategist at Macquarie. That’s because the prices of other commodities—iron, food, aluminum—could rise as the energy costs to produce and transport them rise.

“Energy price shocks transmit into production costs across virtually every sector of the global economy,” Wizman wrote. It is a knock-on effect that central bankers “must be keeping in mind as they recall the pattern from 2020-2024.”

The Case Against Hawkishness

Others are a bit more sanguine about inflation risks.

Markets “seem to be haunted by the ghosts of 2022,” wrote Bank of America economist Aditya Bhave, prompting investors to mistakenly anticipate a less dovish Fed this year.

The central bank raised rates aggressively after the Ukraine invasion in 2022, but that energy shock hit a much different U.S. economy, he noted. The unemployment rate when the Ukraine war started was below 4%, inflation was already over 5%, job growth was booming after the toll COVID inflicted, and “consumers were flush with COVID stimulus cash,” he wrote.

Demand was strong, enabling the Fed to prioritize bringing inflation back to 2% without majorly damaging the economy.

“By contrast, we now have a soft labor market, moderately elevated inflation and more modest fiscal support,” he wrote. “This sets us up for a more dovish Fed response if the oil shock is persistent.”

The job market is “too weak for oil prices to trigger sustained inflation,” wrote Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics. The country added an average of 17,000 jobs a month over the last three months, according to last week’s jobs report.

And if oil prices stay high, consumers may cut back on spending as they feel pain at the pump. Energy-intensive businesses may also feel even more uncertain about the path ahead, Tombs added, weighing on hiring and thus economic activity in the months ahead.

“We think the weakening labor market will be the FOMC’s main worry by the summer,” Tombs wrote, prompting the Fed to cut rates three times this year—much like it did in 2024 and 2025.

No Clear Message

The Fed, however, may opt not to send any clear hints at its meeting next week.

Fed Chair Jerome Powell, whose term ends in May, is due to hold his regularly scheduled press conference on Wednesday. Reporters are sure to ask him to describe the debate among the Fed’s 19 committee members. Each of them, too, will release their quarterly forecasts for the economy—including whether they may support a rate cut this year.

“It’s too soon to say with any certainty when (or even if) the FOMC will ease after holding in March,” wrote Derek Tang, CEO of Monetary Policy Analytics, who sees the Fed cutting once this year in June.

The Fed’s textbook response would be to look past the inflationary impacts of short-lived energy shocks, he wrote. It’s one reason why Fed officials tend to focus on core inflation—price indices that remove more volatile food and energy prices.

“But the Fed’s wherewithal to look through a supply shock has been worn down somewhat by the bruising experience of recent years,” Tang wrote, pointing to a “prolonged” and still-unfinished return to 2% inflation after 2022.

There are many differences between now and 2022, he wrote. For starters, the Fed had to raise rates aggressively in 2022 because its benchmark rate was effectively 0% — it’s now significantly higher at 3.5% to 3.75%. But Fed officials are likely to “remain tentative about any further movements in the funds rate” for now, he wrote.

The Fed is “likely to proceed cautiously with further cuts as long as downside labor market risks seem contained,” and the job market stays stable, wrote Matthew Raskin, a Deutsche Bank strategist.

“But if the war comes to a relatively quick conclusion and oil prices retrace, some Fed easing this year is likely to be priced back in,” he added.

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