The US Federal Reserve is in a critical phase of watching to determine whether the surge in crude oil prices due to the Iran conflict will lead to persistent inflation or just a temporary disruption. Fed policymakers have signaled their willingness to keep interest rates unchanged if the cost increases are concentrated in gasoline prices, but concerns are growing if price pressures start to spread to other goods and services.
Economists warn that the history of pandemics has shown that supply shocks can cause prolonged inflation. With the 2% inflation target missing for five years, coupled with the impact of import tariffs and the ongoing energy crisis, the Fed’s credibility in stabilizing long-term price expectations is now in question. Most analysts believe the Fed will maintain the status quo at its meeting on Thursday.
One unique factor to watch is the use of tax refunds by consumers. While tax refunds increased by 20%, about a third of those funds are used just to pay for everyday gasoline costs. This has reduced the expected economic stimulus, and has dampened consumer spending growth, the lifeblood of the US economy.
While markets are beginning to forget about interest rate cuts this year, some economists such as Luke Tilley predict three rate cuts could begin as early as July. His argument is that soaring energy costs will eventually “kill” consumer demand. As consumers cut back on spending, firms will have to stop raising prices to keep the market in line, which will indirectly lower inflation.
This week’s meeting is likely to be Jerome Powell’s last as Fed Chairman before his term ends on May 15. The path for his successor, Kevin Warsh, is now becoming clearer after the Justice Department dropped a criminal investigation into Powell. Powell is expected to maintain maximum policy flexibility to ease the transition to Warsh in this very challenging economic environment.
