For much of the past year, the Federal Reserve maintained a wait-and-see stance, assessing the economic impact of the comprehensive policy changes implemented by President Trump—policies that reshaped global trade dynamics and disrupted labor markets.
Now, the conflict involving the U.S. and Israel against Iran has once again placed Fed officials in a similar dilemma. This situation is likely to result in a pause in interest rate cuts unless the labor market shows significant deterioration.
The Fed has observed fragile signs in the labor market but has not yet identified severe cracks requiring immediate intervention. Data scheduled for release this Friday is expected to support this assessment.
However, the core challenge facing the Fed lies in the subsequent developments. The Middle East conflict has already disrupted supply chains, driven up prices of commodities such as gasoline and fertilizers, and increased shipping costs.
As a result, overall inflation is expected to rise in the coming months. Faced with higher spending on certain goods, consumers are also anticipated to reduce their expenditures to some extent.
If the conflict prolongs, the economic impact will intensify. Officials are concerned about the extent of consumer spending cutbacks—especially since consumer spending supports approximately two-thirds of U.S. economic growth. Businesses, still adjusting to last year's tariff shocks, have slowed hiring. Although large-scale layoffs have not yet occurred, any further pressure on profit margins could change this situation.
Nevertheless, economic growth and the labor market are not the only concerns for policymakers. They are also worried about inflation, which has remained above the 2% policy target for nearly five consecutive years. This concern complicates the decision of whether to respond to the impending price increases. In the past, the Fed has chosen not to intervene, hoping that the negative impact on growth would outweigh persistent inflationary pressures.
Federal Reserve Chair Jerome Powell stated this week at an event, "Repeated supply shocks of this kind could lead businesses, price setters, and households to broadly expect higher inflation in the future. Why wouldn’t they?"
Despite this risk, Powell did not express urgency for immediate action. Instead, he indicated that current Fed policy is "in a good place to wait and see how the situation evolves."
John Williams, President of the New York Fed and a key ally of Powell, echoed this view this week. He warned that the conflict "could trigger a large-scale supply shock with significant effects: raising inflation through soaring intermediate goods costs and commodity prices, while simultaneously dampening economic activity."
Williams acknowledged that some effects "have already begun to appear," but he believes the inflation spike caused by the war will be temporary.
He predicted that the unemployment rate would decline slightly from the current 4.4%, and that annual inflation would settle around 2.75%. The Fed's preferred inflation measure, the Personal Consumption Expenditures (PCE) price index, stood at 2.8% in January.
