WASHINGTON (TNND) — Higher oil prices that are likely to linger after the war in Iran are throwing a new hurdle in front of the Federal Reserve, raising the risk of a fresh wave of inflation as the labor market has sputtered.
Oil prices have surged to over $110 a barrel since the war in Iran started. Iran has blocked nearly all traffic from moving through the Strait of Hormuz, a vital chokepoint where 20% of the global oil supply passes through. Energy prices will likely keep climbing as the conflict continues and may stay elevated even once it ends due to damage to oil infrastructure and uncertainties about moving cargo through the strait.
More expensive oil has already sent gas prices to the highest level in four years at $4.14 a gallon in a painful pinch on consumers’ budgets, more than $1 higher than before the war. Those costs ripple through the economy with higher costs for producers to manufacture and ship products, which may lead to businesses raising prices to compensate.
“It goes through everything, and then it screws with your consumer demand,” said Russell Rhoads, a clinical associate professor of financial management at Indiana University’s Kelley School of Business. “If it costs you an extra $20 or $30 a week to get back and forth to work, you’ve got to find that somewhere and it comes out of discretionary spending.”
A surge in energy costs is already reshaping expectations about what the Fed will do next and forcing officials into a difficult position.
The central bank was already widely expected to hold steady at its meeting at the end of the month, but markets have consistently pushed back expectations on when rates will be cut again — if at all. Markets see the most likely next move from the Fed being a rate hike, a flip from the beginning of the year when investors anticipated at least one cut.
After five years of elevated inflation, many consumers have little wiggle room in budgets with higher gas prices risking cutbacks elsewhere and the consumer spending that powers the American economy.
The Fed’s preferred gauge of underlying inflation was already moving up before the oil shock, adding to concerns about getting it back to the 2% target. Two inflation indexes, the personal consumption expenditures and the consumer price index, will be released later this week that capture data from the start of the war.
The question is whether the Fed will treat the oil spike as a temporary or a lasting threat to progress on inflation. Historically, the Fed has tried to look past short-term energy shocks and focus on long-term inflation.
“At minimum, this puts them in a wait-and-see attitude, and the markets never like that. But I think the data is going to push us more toward a hike versus a cut to being the next move,” Rhoads said.
During an event at Harvard University last week, Fed chair Jerome Powell said the Fed can look past the initial shock from the war but may have to act if price increases start to shift consumer expectations about inflation. He cautioned that after five years of elevated inflation, it was harder to assume the public wouldn’t expect higher prices over another supply shock.
“It’s something we will eventually, maybe, face the question of what to do here. We’re not really facing it yet because we don’t know what the economic effects will be,” he said. “We feel like our policy is in a good place for us to wait and see how that turns out.”
The Fed has been in an extended holding pattern as officials tried to parse what the economic fallout would be from Trump’s aggressive use of tariffs that upended global trade. Escalating oil prices are threatening to put them into a deeper bind with higher inflation and a weaker economy.
Officials have been trying to strike a balance between getting inflation to return to the 2% target while keeping a stumbling labor market from tipping over the edge.
Job creation has slowed and the economy has shed positions in five of the last 12 months. The primary driver of job creation has been concentrated in health care and social assistance, while the rest of the private sector has cut positions over the last year.
Elevated inflation with a cooling labor market pulls on both ends of the Fed’s dual mandate of maximum employment and stable prices, creating a dilemma on how to move rates. Cutting rates too quickly risks sending inflation higher, while raising them could send unemployment higher. With oil prices surging, the Fed may have less flexibility and may be forced to choose between targeting inflation or protecting the job market, a trade-off they hoped to avoid this year.