The Fed’s latest inflation risk: war

The deadly conflict in the Middle East threatens to upend the Federal Reserve's fight against inflation just as the central bank was making solid progress in curbing price spikes.

The violence in the region has prompted senior U.S. lawmakers to raise the threat of oil sanctions on Iran amid questions about its role in attacks by Palestinian militant group Hamas. Oil prices had already been rising because of production cuts from Saudi Arabia, and the U.S. and its allies have worked for over a year to contain the fallout for energy markets from Russia’s war in Ukraine.

The government reported Thursday that inflation in September continued this summer’s trend of moderate monthly increases, though prices rose a slightly hotter-than-expected 3.7 percent from a year ago. That’s unlikely to shift the path of Fed Chair Jerome Powell’s interest rate hike campaign, which could already be over. But geopolitical tremors could complicate the picture, with the biggest question centered on how the Mideast conflict will affect output by Iran, the world’s eighth-largest oil producer.

“Direct conflict with Iran that involves its oil production and refining facilities… is the major emerging risk to restoring price stability in the U.S. and global economies,” said Joseph Brusuelas, chief economist at RSM US.

Pioneer Natural Resources CEO Scott Sheffield issued a similar warning on Wednesday, saying, “If Iran enters the war, we’re going to see much higher oil prices.”

The Fed’s concern is that higher energy costs could push up prices elsewhere, from plane fares to industries heavily reliant on shipping. Gas prices — a central focus of the Biden administration’s messaging around improvements in inflation — also make up a sizable portion of consumer budgets and rising costs at the pump could make people more pessimistic about the possibility of more price increases. That’s a situation the Fed wants to avoid as it tries to keep inflation from becoming entrenched in people’s minds.

Indeed, Powell has admitted that the Fed has no real ability to combat spikes in global oil prices, which are mostly determined by geopolitical factors and production decisions by big players like Saudi Arabia.

That raises an even more economically unsavory possibility for President Joe Biden heading into an election year: Oil prices could rise, while the economy slows under the strain of high borrowing costs imposed by the Fed, leading to both higher inflation and slower growth.

That would leave central bank officials with “no good options,” Markets Policy Partners researchers said in a note to clients, adding that they would not expect them to let up if inflation stays high: “We anticipate that (at least for the first half of 2024), monetary policymakers will err on the side of controlling inflation.”

Most central bank officials in September were already closely watching the risk that rising energy prices “could undo some of the recent disinflation” or help make price spikes more persistent, according to newly released minutes from their rate-setting meeting. On Thursday, the U.S. Energy Information Administration said it expects oil prices to rise to $95 a barrel next year, compared to around $86 per barrel this week.

“So far, the price impact of the latest Middle East developments has been contained and relatively limited as markets have traded on the view that the conflict is unlikely to extend in a major way to other parties, particularly Iran,” said Mohamed El-Erian, chief economic adviser at the European insurance giant Allianz. He noted that oil prices had already been rising in prior months, including September.

Still, he said, “Both Fed officials and markets are monitoring closely the possible spillover of higher oil prices to other goods and services."

Meanwhile, there are other risks looming for the inflation outlook, including an auto worker strike that could further disrupt vehicle production as well as impacts from El Nino weather patterns this winter.