After the United States and Iran clashed, a surge in prices and a hiring freeze hit at the same time, trapping policymakers at the U.S. Central Bank, the Federal Reserve (Fed), in a dilemma with little room to maneuver.
Since the oil shock triggered by the 1973 Arab-Israeli war, the Fed is facing a similar dilemma again for the first time in about half a century. That oil shock produced the notorious stagflation in which soaring prices and a recession overlapped. However, experts said the strength of the U.S. economy and its industrial structure today are markedly different from 50 years ago, and the Fed is unlikely to take an extreme prescription by aggressively raising rates as it did in the past and plunging the economy into a deep, self-inflicted downturn.
On the 18th (local time), the Fed is almost certain to hold its benchmark rate at the current 3.5%–3.75% in a regular Federal Open Market Committee (FOMC) meeting that wraps up a two-day schedule. Initially, experts expected the Fed to keep rates at this meeting and begin full-fledged cuts starting in June.
But with the United States and Israel unexpectedly invading Iran, every rate outlook unraveled. Fear that roughly 20% of the world's oil supply could be blocked at any moment swept markets, complicating the calculus. In particular, with international oil prices soaring nearly 50% in two weeks, the shock waves are driving up transportation costs, food, and utility bills in succession.
The Fed shoulders two core mandates at once: price stability and maximum employment. When oil prices jump and inflation rises, it must raise rates to drain money from the market. At the same time, if that shock cuts investment by corporations and increases the unemployed, it must instead lower rates to loosen the money spigot. The Fed is in the harsh position of having to choose between two prescriptions that point in entirely different directions.
Experts diagnosed that the Fed is in a situation where it must decide which side to sacrifice between prices and jobs. In setting rates, the Fed pays the closest attention to the personal consumption expenditures (PCE) price index as an inflation gauge. The index is compiled by the Bureau of Economic Analysis (BEA) under the Commerce Department, aggregating price changes for goods and services that a household actually made expenditure on. The PCE index had already turned upward in January, before the Iran invasion erupted. That means inflationary embers were rekindling even before the energy institutional sector shock was fully reflected in the data. This inflationary trend itself is acting as shackles that make it hard for the Fed to cut rates rashly.
A string of major shocks erupting over the past five years is also cited as a reason for caution in this rate decision. Starting with the collapse of global supply chains during the COVID-19 pandemic in 2020, the Fed has been hit by the Russian invasion of Ukraine, the shock from punitive trade tariff impositions, and now instability in the Middle East. Each time the Fed steadily approached its 2% inflation target, these events reignited prices.
Quoting experts, AP said, "Fed officials remember misjudging the early signs of inflation as transitory and then facing a serious backlash," and "they will thoroughly assess how the surge in energy prices ripples through the real economy and will not lower their guard until clear signals of cooling inflation appear." Having once had to carry out steep, consecutive rate hikes to make up for lax judgment during a previous recession, the prevailing view is that this time they will decide carefully.
On top of that, the Fed is at a major inflection point with a change at the top. President Donald Trump has named former Fed Governor Kevin Warsh as the next chair to succeed Jerome Powell, whose term ends in May. The nomination is currently undergoing Senate confirmation. With a new chief set to take office and a potential shift in currency policy philosophy ahead, the current leadership lacks justification to sharply twist the course of rate policy during a transition.
Experts said that while the current crisis resembles the first oil shock in 1973 on the surface, its internal trajectory will likely be vastly different. In the 1970s, the U.S. economy was centered on manufacturing. A surge in oil prices directly translated into a broad industrial paralysis and severe stagflation. To suppress it, the Fed pushed rates into double digits without hesitation, driving the economy into a deliberate recession.
Today, with services and advanced technology making up a larger share of the U.S. economy, energy dependence has fallen significantly compared with the past. And as the United States itself has risen to the ranks of the world's largest oil producer, it has built-in buffers to absorb external shocks. From the Fed's standpoint, there is no reason to pull out the rate-hike card that would sap economic strength, fixated on the single goal of taming inflation as it was 50 years ago. The Wall Street Journal (WSJ), citing experts, said, "Rather than acting immediately, it is time for the Fed to wait for concrete signs of broad-based weakness to unfold across the economy and then respond."