Before the Federal Reserve has even completed its battle against the previous round of inflation, the United States appears to be facing a new wave of price increases. As the conflict involving Iran drives fuel costs higher, expectations are growing that domestic US markets will be affected. Consumers, bond traders, and economists are now forecasting rising prices over the coming year. Even before the recent surge in energy prices—and prior to the arrival of the next Fed Chair nominated by US President Donald Trump—the central bank's credibility in fighting inflation was already under scrutiny.
An energy price shock could push the timeline for achieving the Fed's 2% inflation target further into the future. The process of lowering inflation has already lasted five years and continues. During this period, prices have been successively impacted by the global pandemic, the conflict in Ukraine, tariffs, and now the war involving Iran.
Individually, each event might appear to be a one-off occurrence. Throughout this period, investors and economists have maintained faith that the Federal Reserve would eventually subdue inflation. But as short-term shocks accumulate, the American public may begin to question whether this crucial "long term" is a realistic goal or merely an illusion.
"The risk with a prolonged oil price shock is that it could be like the straw that breaks the camel's back," said Ethan Harris, former head of global economic research at Bank of America Securities. "After five years of elevated inflation, you're facing another round." He believes that even if this lasts only a few months, it could be enough to convince people that "high inflation is here to stay."
In recent months, Federal Reserve officials have begun to notice market concerns about the central bank's genuine commitment to its persistently missed inflation target. Cleveland Fed President Beth Hammack noted late last year that "market participants" were discussing whether the central bank would tolerate inflation slightly below 3%. She stated at the time, "Bringing inflation back down to 2% is crucial for the Fed's credibility." When asked at an event in January about the Fed's projections showing inflation not reaching the target until 2027, and how "realistic" taming inflation really is, New York Fed President John Williams replied, "Completely realistic."
A key role in reinforcing this message may fall to Kevin Warsh, President Trump's nominee for the next Fed Chair. He is scheduled to succeed Powell in mid-May, though the timeline could be delayed. Warsh will need to demonstrate to investors his willingness to act independently of the President, despite Trump's insistence that inflation has been defeated and his use of growth-promoting low interest rates as a "litmus test" for selecting the next chair.
Since late last year, the Fed's preferred consumer price measure has hovered just below 3%. While this is significantly lower than the post-pandemic peak of over 7%, it is not low enough for Americans to dismiss high prices entirely. A significant proportion of small business owners report that inflation is their most pressing concern. US voters in an election year continue to rank inflation as a top priority. And this is all before price increases stemming from the Iran conflict impact households and businesses, with gasoline prices already up over 30% and diesel prices rising around 40%.
"The pandemic was a one-time event, right? This energy supply shock is a one-time event," Fed Chair Jerome Powell said during a press conference following the March policy meeting, also referencing the oil price spike after Russia's invasion of Ukraine. "I don't know if the world has changed in a way that leads to more supply shocks," Powell stated. But, "the supply shocks we've seen over the past five years are more than we saw for many years prior. That's a fact."
These are precisely the kinds of obstacles central banks struggle to counter, as their anti-inflation tools rely on managing demand. What they can do is maintain confidence that the path will eventually smooth out, ensuring one round of price hikes doesn't trigger a chain reaction. In other words, they must keep long-term inflation expectations anchored.
Overall, the Fed has been successful in this regard. Even during the worst of the post-pandemic inflation, some closely watched long-term expectation measures in the bond market did not surge significantly. In recent weeks, the five-to-ten-year breakeven inflation rate, which measures the yield difference between regular Treasuries and inflation-protected bonds, has shown little volatility compared to last year's average.
Regarding consumers, last week's University of Michigan survey showed their one-year inflation expectations rose, but their expectations for five to ten years ahead edged slightly lower. Discussing the potential impact of the Iran conflict at an event at Harvard University on Monday, Powell said inflation expectations appear "well anchored beyond the short term," and that the Fed is monitoring the situation closely.
Nevertheless, former BofA economist Harris noted that bond market indicators and economists' forecasts often align closely with the Fed's own messaging, which might indicate "a bit of overconfidence." In contrast, surveys of consumers, whose behavior actually shapes the economy, show higher inflation expectations, which he suggests indicates the Fed's credibility has "already taken a small hit."
Research shows that public confidence in the Fed ultimately winning the inflation fight is crucial for dampening potential shocks that could otherwise be worse. For instance, a New York Fed study indicated that anchored expectations helped contain wage pressures last year, partly explaining why tariff increases didn't lead to broader price hikes.
But as inflation remains above target, this belief may become harder to sustain. Fed research points out that expectations may be more fragile than in the past. Officials are warning about this. Kansas City Fed President Jeff Schmid warned on Tuesday that inflation could stall around 3%, stating, "We should not assume now that inflation from oil price increases is just transitory."
Americans have been thinking and talking about prices for five or six years, so "sensitivity is amplified," Philadelphia Fed President Anna Paulson said last week. "The pass-through from fuel and fertilizer price increases to inflation expectations faces risks of being faster and potentially more persistent." She pointed out that the wide range of values in household and business surveys is a sign of vulnerability to the next shock.
And with the outbreak of the Iran conflict, that next shock is precisely the imminent situation. "Given all the events in recent years, can the Fed still sell the American public (and itself) on another round of 'transitory' inflation narrative?" economists at BNP Paribas wrote last month. "Or will officials deem the risk of trying too great?"
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