By Howard Schneider and Ann Saphir
WASHINGTON, April 17 (Reuters) – Iran’s move to reopen the Strait of Hormuz and a sharp drop in oil prices on Friday boosted bets the Federal Reserve may resume its interest rate cuts as soon as December, but its policymakers still face a tangled outlook ahead of their April 28-29 meeting and remained cautious about the risks of higher inflation.
“Add a military conflict in the Middle East to the task of predicting the course of the economy, and things get very complicated,” said Fed Governor Christopher Waller, who had advocated for rate cuts to bolster the labor market but has grown more wary of inflation and agreed with the central bank’s decision last month to keep rates on hold.
A reopened Strait of Hormuz and falling oil prices could pave the way to rate cuts later this year, but there is no guarantee, given “the possibility that this series of price shocks may lead to a more lasting increase in inflation,” he said in a speech in Auburn, Alabama.
“I see a forecast in which underlying inflation would continue to move toward 2%, leaving me cautious about rate cuts now and more inclined toward cuts to support the labor market later this year when the outlook is more steady,” he said.
Following a ceasefire announcement between Israel and Lebanon, Iran said on Friday it would reopen the strait, which handles about a fifth of the world’s oil supply, to shipping for the duration of a current ceasefire with the U.S.
Global oil prices that had been stuck around $95 a barrel plunged below $89, and traders in contracts tied to Fed interest rates changed their view from the central bank remaining sidelined until well into 2027 to a resumption of rate cuts by late this year.
Neil Dutta, head of economic research for Renaissance Macro Research, said the Fed may now be able to set aside the stagflationary concerns of higher inflation and slowing growth from the oil shock and pursue “good-news” rate reductions based on a renewed drop in inflation.
“This will be much better for inflation than it will be for growth, though it will be good for both,” as consumers’ purchasing power improves and they spend less on basics like gas, he wrote in a note. The average price of gasoline already had eased from a recent high above $4.15 a gallon to around $4.07 on Friday, according to data from motorist advocacy group AAA.
FED OFFICIALS HAD GROWN MORE HAWKISH RECENTLY
In a recent interview with Reuters, San Francisco Fed President Mary Daly noted how the evolution of the conflict, and the possible response of oil prices if hostilities were to ease, could influence the Fed’s confidence that inflation will decline from current levels about a percentage point above the central bank’s target.
“As long as we have the conflict resolved soon, you would find us in a place where it just takes longer, but it doesn’t stall the progress” on inflation, Daly said in the interview. “It just takes longer for all that to work itself through.”
The Fed is still likely to leave its benchmark overnight interest rate in the 3.50%-3.75% range at its meeting later this month, with inflation still showing little progress in recent months and new risks surfacing around its direction.
But until the developments on Friday, Fed officials’ language had begun to grow more hawkish as concern intensified that the seven-week war in the Middle East was no longer an event they could “look through” as a temporary disruption, but was leading to broader price pressures.
New York Fed President John Williams, in remarks this week, had begun sketching out how the conditions for a more sustained inflation impact from the war had “already begun to play out” through higher fuel costs and larger supply chain issues that could be seen “in the form of higher airfares, groceries, fertilizer, and other consumer products.”
A vice chair and permanent voter on the central bank’s rate-setting Federal Open Market Committee, Williams said that “even based on what we’ve seen already, inflation will be well above 3% over the next few months,” a significant miss for the Fed and heading in the wrong direction based on the Personal Consumption Expenditures Price Index, the gauge the central bank uses to set its inflation target.
In February, the last month for which data is currently available, headline PCE was 2.8% on a year-over-year basis and the core measure, excluding food and energy, was 3%. Some analysts expect the core PCE to have jumped to 3.2% in March. That data will be released on April 30, a day after the end of the Fed’s next meeting.
POSSIBLE RELIEF FOR CONSUMERS
How the latest events shift the Fed’s outlook for the economy, inflation and interest rates depends on whether the seemingly positive progress towards a resolution of the conflict continues and drives oil prices even lower.
President Donald Trump this week labeled as “fake” the inflation that has occurred as a result of his decision to launch air strikes against Iran, and a sharp jump in the headline Consumer Price Index in March, the fastest since the peak of the pandemic-era inflation surge in 2022 under former President Joe Biden, was largely the result of energy costs alone. Economists exclude energy and food prices from the narrower concept of “core” inflation that better captures underlying inflation trends.
But Fed officials and commentary from the Fed’s “Beige Book” survey of economic reports from around the country had begun to focus on higher core inflation that policymakers saw possibly developing from the energy shock as firms over time reset what they charge to account for higher input costs, and fuel and energy contracts adjust to account for market pricing.
The relief in oil prices, if it sticks, will be felt broadly as consumers get relief at the gas pump and are able to restore spending that may have been diverted from other goods and services, a potential boost to economic growth.
“Every dollar the consumer spends on increased energy costs is $1 they’re not spending on other things,” Fed Governor Stephen Miran said earlier this week as he advocated for a rate cut at the Fed’s next meeting. “I don’t think that’s the type of thing that is going to drive us into recession, but it’s a drag on growth, and in a labor market that was very gradually drifting away from full employment, it’s the type of thing that might make you concerned.”
(Reporting by Howard Schneider and Ann Saphir, Editing by Chizu Nomiyama and Paul Simao)
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