Minneapolis Fed President Neel Kashkari has reaffirmed his hawkish position, stating that allowing elevated inflation to become a new normal is unacceptable and that interest rate increases remain a potential policy response. Speaking at an event in Marquette, Michigan, on May 8, Kashkari cited significant uncertainty stemming from the Iran conflict. He explicitly warned that a prolonged closure of the Strait of Hormuz would likely necessitate raising interest rates.
Kashkari's comments coincided with reports of explosions near the port cities of Bandar Abbas and Sirik in Iran's Hormozgan province. The U.S. military confirmed targeted strikes on Iranian military facilities, while Iran claimed it had retaliated against three U.S. destroyers, inflicting significant damage. Following these developments, Brent crude futures surged over 2%, breaching the $100 per barrel mark. U.S. stock markets reversed gains, with all three major indices closing lower.
Kashkari's remarks are not an isolated view but reflect a deep and growing divergence within the Federal Reserve regarding the economic impact of the Strait of Hormuz crisis. The Federal Open Market Committee's meeting concluding on April 30 maintained the federal funds rate target range at 3.5% to 3.75%. However, the decision was met with a rare four dissenting votes, the highest number of objections since 1992. Kashkari, along with Cleveland Fed President Loretta Harker and Dallas Fed President Lorie Logan, supported holding rates steady but jointly opposed the policy statement's wording, which they believed suggested a potential future rate cut. Meanwhile, Governor Michelle Bowman dissented in favor of an immediate 25 basis point cut.
Kashkari explained the rationale behind his dissent, stating the objection was to the forward guidance because signaling that the next move could be a cut was inappropriate. The core of the disagreement centered on a phrase in the April statement indicating the Committee would assess the "appropriate extent of any additional policy firming." Fed watchers interpreted "additional policy firming" as implying a continuation of the rate-cutting trend. The hawkish faction strongly disagreed with this implication.
Kashkari's post-meeting statement argued that even under an optimistic scenario where the Strait of Hormuz reopens quickly, the core inflation rate in the U.S. would likely remain around 3% for the year, significantly above the Fed's 2% target. He contended that this level of inflation, persisting for a third consecutive year near 3%, poses a substantial risk to inflation expectations and might require a series of rate hikes to uphold the Fed's credibility.
Cleveland Fed President Harker was more direct, stating that the Iran war and subsequent oil price surge pose a clear threat to the 2% inflation goal, with inflationary pressures still widespread. She asserted that, given the current outlook, a clear easing bias is no longer suitable. The unified stance of these three hawks marks a significant public rift within the Fed in response to the crisis.
Kashkari's recent comments have effectively introduced the option of rate hikes into the Fed's policy narrative. He outlined three potential scenarios: in an extreme case of a long-term Strait closure, rate hikes would be a necessary response; if the Strait reopens swiftly, rates would simply need to be held steady for longer; and various unpredictable geopolitical outcomes lie between these two extremes.
The root of the Fed's internal conflict traces back to the quasi-blockade of the Strait of Hormuz since late February, following a U.S.-Israel joint attack on Iran. Iran's blockade has disrupted about 20% of global oil and gas transit, reducing global oil supply by up to 14 million barrels per day. Brent crude futures have risen over $30 per barrel since February 27, with spot prices for some non-Middle Eastern crudes, like Norway's Sverdrup, soaring to $150 per barrel.
A U.S. attempt to break the deadlock with a "Freedom Plan" to escort commercial ships through the strait was suspended within 48 hours after exchanges of fire with Iran. President Trump announced the pause, claiming it was to observe if a deal with Iran could be finalized. However, a senior Iranian advisor declared the strait closed unless decided by Iran's national will and stated that a state of war persists with the U.S. The situation escalated further on May 7-8 with U.S. strikes on Iranian ports, which Trump downplayed as a "tap on the wrist" while insisting a ceasefire remained in effect.
Amid this geopolitical storm and policy dilemma, Kashkari emphasized a fundamental issue: the U.S. has experienced inflation above the Fed's target for five consecutive years, severely testing the central bank's credibility. He stressed that high inflation cannot be allowed to become the new normal. In prior writings, he argued that maintaining anchored long-term inflation expectations is essential for maximum employment and a vibrant economy, even if fighting inflation requires rate hikes that might increase unemployment. This stance prioritizes the inflation mandate, operating on the premise that unanchored expectations would make both price stability and full employment unattainable.
This environment presents an immediate and formidable challenge for incoming Fed Chair Kevin Warsh. As noted by LPL Financial's chief fixed income strategist Lawrence Gillum, the path ahead for Warsh will undoubtedly be arduous.
In response to these uncertainties, market expectations for interest rates are shifting subtly. Pricing in swaps tied to Fed policy now implies a greater than 50% probability of a rate hike by April of next year, with expectations for a rate cut pushed back to early 2028. Analysts suggest a stabilizing labor market will allow the Fed to focus squarely on combating the oil-driven inflation shock. Concurrently, the 30-year Treasury yield has surpassed 5% for the first time this year, with some market participants expressing surprise that markets are still reluctant to price in a potential hiking cycle.
Despite the hawkish rhetoric, the Fed is not unified. New York Fed President John Williams, a key figure, attempted to calm markets on May 4. While acknowledging high inflation, mixed employment signals, and significant uncertainty from the Middle East, he stated that none of the data he has seen indicates a need for rate hikes in the near term. Williams raised his 2024 inflation forecast to around 3% and projected inflation would not return to the 2% target until 2027. His comments were seen as an effort to bridge internal divisions and stabilize market expectations following the contentious vote. He emphasized that, despite individual dissents, the consensus on the overall policy stance within the Fed is much broader than the voting results suggest.
The Fed is currently in a critical leadership transition. Current Chair Jerome Powell's term is ending, and Kevin Warsh, nominated by President Trump, is set to take over on May 15. Trump has repeatedly pressured the Fed for rate cuts, but the inflation pressures driven by the Iran war are creating a nearly insurmountable policy barrier even before his nominee assumes office.
Comments