Will The Israel-Iran Conflict Reshuffle The Fed’s Policy Playbook?
By James Picerno | The Milwaukee Company
The Israel-Iran conflict adds more uncertainty for inflation and the economic outlook.
The Fed is expected to hold rates steady this week, with easing possible in September.
Although current conditions still favor cutting rates, the Fed appears to remain cautious on revising policy due to uncertainty about tariff-induced inflation and the possibility of a widening Middle East conflict.
Macro anxiety in markets was starting to moderate in early June, if only slightly, but the shift toward a calmer, gentler pathway outlook was quickly challenged when Israel launched targeted airstrikes on Iran last Friday.
Ahead of the Federal Reserve’s policy announcement on Wednesday (June 18), the risk of a wider war lurks anew in the Middle East, an event that could pull other nations into the fighting. For the central bank, it’s another wild card for assessing the economic outlook that’s still off balance from tariffs.
The Fed is widely expected to keep its target rate unchanged this week, and at the July FOMC meeting too. The odds for the next rate cut have recently been pushed forward to September. Will the spike in geopolitical tension alter this forecast, along with the Fed’s plans?
Policy at the moment remains tight, relative to the implied signals from the latest inflation data. The year-over-year changes for the consumer price index (CPI), based on the headline and core readings, are still well below the Fed’s median 4.33% target rate.
TMC Research’s multi-factor Fed funds model indicates that the degree of policy tightness has eased recently, but the current median Fed funds target rate is roughly 70 basis points above our estimate of the neutral rate.
The central bank’s view is that inflation uncertainty is still too high to consider rate cuts and so a policy that’s tighter than current economic conditions imply is warranted. Former Cleveland Fed President Loretta Mester last week said: “We don’t know really how the second half of the year is going to play out." She explained: "The Fed is on hold until we get a little more clarity about not only the magnitude of the tariffs and the breadth of the tariffs, but what effect they all have on inflation and what effect the tariffs and other policies, including the budget bill, will have on growth and employment."
The Israel-Iran conflict further complicates the analysis, in part because the fighting has raised crude oil prices, a key component in headline inflation. So far, the rise in energy has been moderate and oil remains within the price range that’s prevailed this year. Iran has threatened to close the Strait of Hormuz, through which roughly a third of the world’s oil and gas is exported via ships. But the threat may be bluster amid reports today that Iran is seeking to de-escalate the fighting with Israel and statements by President Trump, who said he will not allow the Strait to close.
Even if energy risk eases, the Fed will continue to struggle with deciding how, or if, to factor in tariffs. To date, the impact on broad price measures has been minimal. Encouraging, but many economists advise that higher inflation due to tariffs has yet to show up in the data and so the latest CPI update could be misleading.
At the same time, there are signs that US economic growth is slowing. Weekly jobless claims have increased to the highest level since October, which raises a warning flag for the labor market outlook. Elevated energy prices could exacerbate the risk. If more signs emerge that economic activity is slowing, the case will strengthen for rate cuts.
The Israel-Iran conflict, however, continues to evolve and so it’s not yet clear how long the attacks will continue and how the residual effects on economic activity will play out. As we write, there are reports that Iran expanded its strikes on Monday.
Israeli Prime Minister Benjamin Netanyahu on Sunday said that his government’s actions could lead to regime change in Iran – an outcome that could add an additional layer of complexity and uncertainty to an already tense geopolitical climate in the region. The aircraft carrier U.S.S. Nimitz is leaving Southeast Asia for the Middle East as part of a planned deployment, a Defense Department official said.
Enter the Federal Reserve, which will try to craft a policy plan that’s appropriate for current and near-term future conditions. Since almost no one expects a change in rates, the market’s focus on Wednesday will be on the central bank’s revised economic projections and Fed Chairman Powell’s press conference.
Meantime, a moderately hawkish policy bias prevails, and a wary Fed appears unlikely to change its stance in the near term, least of all at Wednesday’s policy meeting.