Energy Shock Persists
The Federal Reserve is facing a difficult test as the war with Iran enters its seventh month, keeping oil prices well above pre-war levels. While prices have dipped from peaks above $100 a barrel, they surpassed $90 this week after renewed fighting. The conflict has halted traffic through the Strait of Hormuz, cutting off access to about 20% of the world's oil and natural gas supplies.[S1]
Central banks typically ignore energy shocks, assuming prices will normalize, but the prolonged nature of this conflict is making that harder. Inflation has retreated from pandemic highs but remains above the Fed's 2% target. Core measures, excluding food and energy, have also been firmer than expected in the first half of the year.[S1]
Other Inflation Pressures
Beyond energy, the massive build-out of artificial intelligence is pushing up costs for skilled labor and computer chips. A renewed trade war with Canada risks higher import costs, and diesel prices near record highs could raise transportation costs for many consumer goods. These factors add to the challenge for the Fed as it tries to assess the inflation outlook.[S1]
Fed Officials Divided
The Fed has held off on raising rates this year, but officials are increasingly divided. Three dissented at July's pause, favoring an increase. Treasury Secretary Scott Bessent argued this week that recent inflation data shows a supply shock, and traditionally you don't raise rates into such a shock unless second- or third-order effects appear. He noted core inflation remains restrained.[S1]
Fed Chair Warsh, in his first keynote at Jackson Hole, said underlying inflation trends have not meaningfully improved and the central bank may need to raise rates. He did not commit to a hike at the next meeting on Sept. 15-16 but said there may be 'work to do' if trends don't improve. Governor Michael Barr echoed that rates may need to rise unless data shows easing.[S1]
Market Expectations
Markets have responded, with the odds of a quarter-point hike at the next FOMC meeting around 66% as of Wednesday, according to CME FedWatch. Ten-year Treasury yields have climbed to highs not seen since 2007. Other central banks, like the European Central Bank, have already raised rates. The Fed will get another inflation report on Sept. 11 before its meeting.[S1]
