By Nick Timiraos
It's happening again.
For the fifth year running, Federal Reserve officials find themselves expecting inflation to fall back to their 2% goal only to be confronted with another disruption that complicates the path. First it was the pandemic's aftershocks. Then, Russia's war in Ukraine. Last year, a sweeping tariff program.
The most recent data suggested inflation progress stalled even before America's war in the Middle East disrupted one of the world's most important shipping routes. The turmoil could send up energy and commodity prices in ways that could further delay reaching the target.
Officials meeting this week face a question that would have seemed unlikely a few months ago: It isn't when they will next cut rates, but whether they can credibly keep telling markets to expect a rate cut at all.
The war is likely to reinforce the consensus around holding rates steady. The harder question is what officials signal beyond the next few months. There are three places to watch:
First is the policy statement. A minority of officials pushed unsuccessfully in January to jettison language hinting that the next move is a cut. Making that change would mark the first explicit acknowledgment that the easing cycle may be over.
Second is the quarterly projections, where each of the 19 meeting participants writes down where they think inflation and rates are headed over the coming years.
Third is the post-meeting press conference, where Fed Chair Jerome Powell can amplify or play down whatever signals emerge from the other two.
The war's effect on energy markets has made the Fed's job more fraught. In the near term, the uncertainty is so pervasive that it virtually guarantees the Fed does nothing, much as officials sat on their hands after the tariff announcements last spring. Powell used the phrase "wait and see" 11 times at a press conference last May.
But the projections force officials to look ahead, and that's where the picture gets more unsettling. The war has widened the range of plausible outcomes for the economy without clarifying which one is most likely. Oil prices could retreat if the conflict is contained or surge further if it escalates, threatening both higher inflation and weaker growth simultaneously.
"The people that were more worried about inflation before are going to be even more worried about it now," said Jonathan Pingle, chief U.S. economist at UBS. "But the people that were more worried about the labor market -- this should probably increase their concern, not lessen it."
The standard advice for a central bank facing an oil shock is to look past it, concluding that the hit to growth and the boost to inflation roughly cancel out. But that advice assumes the public trusts that inflation will come back down. After five years of above-target inflation and a series of shocks that keep reminding consumers of rising prices, that trust is harder to take for granted.
"Do we really want to do another 'Transitory 2.0'?" said Minneapolis Fed President Neel Kashkari in an interview this month. In December he penciled in one cut for this year.
Part of the problem is that the economy is being hit with simultaneous shocks whose effects can't be isolated. In addition to tariffs and the looming oil shock, an immigration crackdown that shrinks labor supply has contributed to a phenomenon where the unemployment rate is barely rising despite anemic job growth.
The inability to disentangle what each shock is doing to the economy "makes it very difficult for the Fed to be particularly decisive," said Eric Rosengren, who served as president of the Boston Fed for 14 years including during a 2008 oil shock.
The rate projections are likely to dominate the reaction to this week's meeting. In December, 12 of 19 officials projected at least one rate cut this year. It would take three of them changing their view to drop the widely watched "median" rate-cut projection to zero. That result would be interpreted as the Fed signaling a much longer pause even though officials don't collectively curate the projections the way they do for the policy statement.
Markets have already repriced sharply. At the end of last week, traders saw a 47% chance of at least one rate cut by December, down from 74% before the Iran war began last month, according to options prices calculated by the Atlanta Fed. The probability of a rate increase by year-end rose to 35% from 8% over the same period.
The stakes are heightened by the looming transition: Powell's term as chair ends in May, making whatever the committee lays out this week the baseline his successor stands to inherit.
When officials revise their inflation forecast higher, the arithmetic of penciling in rate cuts gets harder, especially for those who think the current rate is already near a level that neither spurs nor slows growth. Cutting rates from a level that isn't restrictive is exceedingly difficult to justify for a policymaker who thinks inflation will end the year close to 3%.
The Fed's preferred measure of underlying inflation -- the core personal-consumption expenditures price index, which strips out volatile food and energy prices -- accelerated to 3.1% in January. It had been as low as 2.6% last April.
Jim Bullard, who was president of the St. Louis Fed from 2008 until 2023, said he would have penciled in one cut at the end of last year but would now remove it. With core inflation above 3% and trending higher, "you wouldn't want to be committing to cuts here," said Bullard, who is now dean of the business school at Purdue University.
Rosengren said the committee's current posture, which implies the next move is more likely to be a cut, has grown harder to defend given the shocks the economy is encountering.
But for officials who were already uneasy about a labor market they have described as fragile or vulnerable, the war should add to those worries. As many as three Fed governors could dissent in favor of a cut this week. If anything, an oil shock that threatens to squeeze households and crimp spending reinforces their case for keeping rate cuts on the table.
The economy is in a fundamentally different place than it was when the war in Ukraine sent commodity prices soaring four years ago. In 2022, employers were adding 377,000 jobs a month, and households had huge savings buffers. Last year, employers added 10,000 jobs a month, delinquency rates are rising, and household savings for the bottom 80% of earners have eroded sharply.
The current situation has far more in common with 1990, when an oil shock from the Persian Gulf War tipped the economy into recession, said Pingle.
Whatever the projections show, the deeper shift may be in the Fed's ability to stay ahead of trouble. For most of the past two years, officials cut rates when the labor market showed signs of softening, confident enough in the trajectory of inflation to buy insurance against a downturn that hadn't yet arrived.
That calculus is now at risk of breaking down.
"The Fed is leaning toward policy ease. That's the big picture," said Vincent Reinhart, a former senior Fed adviser who is now chief economist at BNY Investments. "But they're not going to cut rates until they're sure inflation is durably lower."
Having lowered rates last year, many officials think they may not be doing much to restrain the economy as it is, leaving little room to cut absent meaningful weakening. The worsening inflation picture makes using what space they have more uncomfortable. "This is a point where they might have to wait and react to the weakness that might unfold," said Pingle.
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