Geopolitical Shocks Reshape Fed's Inflation Fight, Complicating Rate Cut Outlook

The Federal Reserve's Inflation Battle: A Complex Path Under Geopolitical Strain

In what is becoming a recurring historical pattern, Federal Reserve officials are once again finding their expectations for inflation to return to the 2% target disrupted by an unexpected turn of events. This marks the fifth consecutive year where efforts to tame price pressures have been thrown off course by unforeseen circumstances. Initially, it was the lingering effects of the pandemic, followed by the conflict between Russia and Ukraine, and last year, a comprehensive tariff plan swept across the economic landscape. Even before the current Middle Eastern conflicts fully impact global shipping lanes, recent data indicates that the disinflationary process has stalled.

The ongoing turmoil in one of the world's most critical shipping routes, with which the U.S. is intertwined, is likely to drive up energy and commodity prices, further pushing back the timeline for achieving the inflation target. Officials at the Fed, in their upcoming meeting, are now grappling with a scenario that seemed improbable just months ago: the question is no longer when they will cut interest rates, but whether they can still credibly maintain market expectations for rate cuts.

Growing Impact of Geopolitical Tensions on Monetary Policy Decisions

The current conflict is likely to reinforce the consensus among officials to keep interest rates on hold. However, the more intricate challenge lies in the signaling they will adopt in the coming months. Three key areas warrant close observation:

• The Policy Statement: In January, a minority of officials attempted to remove language that implied the next move would be a rate cut, but they were unsuccessful. If such a change is made now, it would represent an explicit acknowledgment that the easing cycle may have concluded.
• The Quarterly Projections: All 19 participating officials will submit their forecasts for inflation and interest rates over the next few years.
• The Post-Meeting Press Conference: Fed Chair Jerome Powell has the ability to amplify or downplay any signals released in the preceding two points during his press conference.

The impact of the war on energy markets has made the Fed's job more arduous. As journalist Nick Timiraos notes, the pervasive uncertainty in the short term almost guarantees the Fed will stand pat, much like officials did after announcing tariff plans last spring. In a May press conference last year, Powell uttered the phrase "wait and see" 11 times.

Looking Ahead: Uncertainty Surrounds Economic Projections

Conversely, the quarterly projections compel officials to look forward, and this is where the outlook becomes more unsettling. The conflict has made the potential economic paths more opaque, making it difficult to discern the most probable scenario. If the conflict is contained, oil prices may recede. However, if it escalates, oil prices could surge further, creating a dual threat of rising inflation and sluggish economic growth.

"Those who were concerned about inflation before will certainly be more anxious now," states Jonathan Pingle, Chief U.S. Economist at UBS. "And those more worried about the labor market – this will likely give them more cause for concern rather than relief."

Timiraos points out that the traditional advice for central banks facing oil shocks is to "look through it," arguing that the hit to economic growth and the boost to inflation will roughly offset each other. However, this advice hinges on the public's belief that inflation will eventually subside. After five consecutive years of inflation above target, coupled with a series of shocks constantly reminding consumers of rising prices, such trust can no longer be taken for granted.

"Do we really want to have another 'transitory inflation 2.0' situation?" Minneapolis Fed President Neel Kashkari questioned in an interview this month. In December, he had predicted one rate cut this year.

Intertwined Economic Shocks and Difficulty in Decisive Action

Part of the problem is that the U.S. economy is being battered by multiple shocks, the impacts of which are difficult to disentangle. Beyond tariffs and the looming oil shock, immigration restrictions have reduced labor supply, contributing to a peculiar phenomenon: despite sluggish job growth, the unemployment rate has barely budged.

"The inability to disentangle the precise impact of each shock on the economy makes it difficult for the Fed to make decisive decisions," says Eric Rosengren, who served as president of the Federal Reserve Bank of Boston for 14 years, including during the 2008 oil shock.

Interest Rate Projections: A Key Driver of Market Reactions

Interest rate projections are likely to be the dominant factor driving market reactions to this week's meeting. In December, 12 of the 19 officials anticipated at least one rate cut this year. Just three changing their minds would shift the closely watched "median" projection for rate cuts to zero. This outcome would be interpreted by the market as the Fed signaling a longer period of holding rates steady, even though officials do not collectively choreograph these projections as they do policy statements.

Markets have already undertaken significant repricing. According to options prices calculated by the Atlanta Fed, last weekend traders assigned a 47% probability of at least one rate cut by December of this year, down from 74% before the Iran war erupted last month. Over the same period, the probability of a rate *hike* by year-end surged from 8% to 35%.

Furthermore, looming personnel changes raise the stakes: Chair Powell's term ends in May, meaning any policy the committee sets this week will be the baseline his successor inherits.

The Difficulty of Justifying Rate Cuts Amidst Rising Inflation

When officials mark up their inflation forecasts, the case for including rate cuts in their plans becomes more challenging, especially for those who believe current rates are already near a "neutral" level. For a policymaker projecting inflation to be near 3% by year-end, justifying a rate cut from an already not-tight-enough level is extremely difficult.

The core personal consumption expenditures price index (PCE) – the Fed's preferred inflation gauge, excluding volatile food and energy prices – accelerated to 3.1% in January. In April of last year, it had fallen to 2.6%.

James Bullard, former president of the St. Louis Fed and now dean of Purdue University's business school, states that if it were late last year, he would have included one rate cut in his plan, but now he would cross it off. "With core inflation now above 3% and trending up, you certainly don't want to be promising rate cuts at this juncture."

Rosengren notes that the committee's current posture, implying a rate cut is the more likely next move, is becoming increasingly untenable given the multiple shocks the economy is currently facing.

Divergent Views and Potential Dissent

For officials already uneasy about what they perceive as a fragile labor market, the war only exacerbates their concerns. As many as three Fed governors might dissent this week and favor rate cuts. If anything, an oil shock that could squeeze household incomes and curb consumer spending might bolster their case for keeping rate cuts on the table.

The economic landscape has fundamentally shifted compared to four years ago when the Russia-Ukraine conflict led to commodity price surges. In 2022, employers added an average of 377,000 jobs a month, and households had substantial savings buffers. Last year, employers added only 10,000 jobs a month, default rates are rising, and savings for the bottom 80% of households by income have dwindled significantly.

Pingle likens the current situation more to 1990, when the oil shock triggered by the Gulf War directly pushed the economy into recession.

A Shift in Fed Strategy: From Preemption to Reaction

Regardless of the projection numbers, a deeper shift may lie in the Fed's ability to preemptively manage risks. For much of the past two years, when signs of labor market weakness emerged, officials would cut rates, confident enough in the disinflationary path to buy "insurance" against a looming recession. But now, that calculation faces the risk of falling apart.

"The overall inclination of the Fed is to ease policy. That's the general direction," says Vincent Reinhart, former senior Fed advisor and chief economist at Mellon Investments. "But they won't cut until they are confident inflation is going to come down sustainably.""

Timiraos concludes that after last year's rate cuts, many officials believe their current policy is probably not all that restrictive, and if the economy doesn't show substantial weakness, their room for further easing is minimal. The worsening inflation outlook makes them even more constrained in using what little room they might have left to cut rates.

"At this point, they may just have to wait and see and only react when the economy actually shows weakness," Pingle sums up.