As fuel prices surge following the outbreak of conflict involving Iran, a question that seemed almost unthinkable just weeks ago has emerged: could the Federal Reserve's next policy move be an interest rate increase?
Financial markets are beginning to consider this possibility. Traders in derivatives markets are pricing in approximately a 25% probability of a rate hike this year. This shift in expectations highlights the direct impact of geopolitical conflict on global energy markets and inflation prospects, forcing investors to reassess the Fed's policy path.
While most economists anticipate the Fed will hold rates steady at its upcoming meeting, discussions about potential hikes are no longer off-limits.
Analysts note that this dynamic not only shatters the widespread market expectation that the Fed would continue cutting rates but also injects significant uncertainty into the future direction of monetary policy, directly affecting bond yields and risk appetite in equity markets.
Federal Reserve officials are scheduled to hold their monetary policy meeting on March 17-18. Markets will closely monitor Chair Powell's remarks for any clues regarding the future path of interest rates.
**Renewed Inflation Worries Spark Early Calls for Hikes**
The sharp rise in oil prices has directly pushed up inflation expectations, prompting some market participants to call for the Fed to take tightening action.
Carl Weinberg, Chief Economist at High Frequency Economics, believes the Fed should raise rates at the upcoming meeting. He predicts that by this summer, oil prices will push the Fed's preferred inflation gauge—the Personal Consumption Expenditures Price Index (PCE)—to a 3.5% annual rate.
"The Fed's job is to minimize the risk of the worst outcome, which is prices accelerating above target," Weinberg wrote in a note to clients.
He added, "Even if the FOMC does not raise rates next week—a possibility we no longer rule out—officials will certainly discuss the issue, and we expect Mr. Powell to inform us of this during his press conference."
Despite these calls for hikes, most economists expect the Fed to refrain from action in the near term. Given the uncertainty created by the conflict, nearly all economists anticipate the Fed will adopt a "wait-and-see" approach.
Former Dallas Fed President Robert Kaplan urged the central bank to remain patient. He stated, "I have a strange feeling that by the end of March, things will look different than they do now."
Former senior Fed official Vincent Reinhart also pointed out that a majority within the Fed still leans towards easing monetary policy, "but is in no rush to do so." He believes, "Events in the Middle East have not altered this direction; they only give you more reason to wait."
Furthermore, Matthew Luzzetti, Chief U.S. Economist at Deutsche Bank, noted that a prerequisite for a rate hike would be not just a rebound, but a strengthening of the labor market. However, the U.S. labor market has been struggling, adding an average of only 6,000 jobs over the past three months.
**Searching for Signals of a Policy Shift**
Although the Fed is highly likely to keep rates unchanged, economists will scrutinize any signals about its future plans.
James Egelhof, Chief U.S. Economist at BNP Paribas Securities, said he would watch for any change in wording from Fed officials to indicate whether they plan to cut or raise rates in the coming months.
The Fed's standard playbook calls for officials to "look through" an oil price shock or treat it as temporary, since inflation associated with rising oil prices is not persistent.
However, Egelhof noted that, given the persistence of high inflation since 2021, now five years on, Fed officials would be deeply divided on whether to employ this approach.
Bill Adams, Chief Economist at Comerica, agreed that the Fed would signal openness to either hiking or cutting rates. He stated, "If inflation were at the 2% target, the Fed would be less concerned about credibility and anchoring inflation expectations than it is now."
Adams indicated that policymakers would likely signal their intention to use their tools to prevent an energy price shock from translating into a rise in trend inflation. "This signals a conditional willingness to hike, but is not a signal of a hike in the near future."
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