Fed Officials Open Door to Rate Hikes as Iran War Energy Shock Keeps Inflation Elevated

On Friday, at a conference in Iceland, Michelle Bowman said something that would have sounded unlikely a few months ago. Bowman, the Federal Reserve's Vice Chair for Supervision and one of its most dovish policymakers, said the war with Iran and the energy shock that came with it could change how she views the outlook for interest rates.

She was careful about it. "It still seems early to assess the size and persistence of the economic effects from the Iran conflict," she said. But if disruptions last well into the second half of the year, she added, broader effects on inflation could begin to show. In that case, she would more likely consider shifting how she thinks about the balance of risks. She stopped short of saying hikes would be required.

Bowman was not alone. Several of her colleagues worry that the energy shock will be hard to dismiss as a temporary factor, in large part because inflation has stayed above the Fed's 2% target for years. That concern has made them willing to consider raising rates to bring prices back in line. Before the U.S.-backed war with Iran began, Fed officials had been looking toward a rate cut. The war has since caused major supply chain distortions and a surge in energy prices. Financial markets now expect the Fed's next move to eventually be an increase from the current benchmark range of 3.50% to 3.75%.

The data released this week gives that thinking some support. On Thursday, the U.S. government reported that the Personal Consumption Expenditures Price Index rose 3.8% year over year in April, up from 3.5% in March. On Friday, a New York Fed gauge meant to capture underlying inflation jumped to 4% in April from 3.5% the month before. Prices for goods and services excluding housing accelerated in April relative to March.

Kansas City Fed President Jeffrey Schmid, speaking at the same Iceland conference, was blunter. His primary concern, he said, is inflation that is too hot and has been above target for too long. He argued that the textbook approach of looking through an energy shock, treating it as something without lasting impact, is not viable right now.

Schmid also raised the balance sheet as a possible tool. The Fed is not very restrictive at this stage, he said, and there is some discussion about what tools it has to become somewhat more restrictive, depending on how the oil shock plays out. Looking at the balance sheet again could create some restriction, he said, suggesting a new drawdown in Fed holdings might provide a headwind for growth.

That idea may meet resistance. Fed Chairman Kevin Warsh has expressed skepticism about using the central bank's bond holdings to supplement interest rate policy. There are also practical limits: money market conditions and the Fed's rate-control toolkit restrict how far those holdings can shrink without causing market volatility, and the Fed is currently rebuilding liquidity after conditions tightened late last year.

Philadelphia Fed President Anna Paulson took a more settled tone while speaking to a business group in New Jersey. She said monetary policy is "well positioned" given the unacceptably high inflation pressures and economic uncertainty, and that the Fed is ready "to react." She called it healthy that market participants have taken on board scenarios in which the funds rate stays unchanged for an extended period, as well as ones where further tightening becomes necessary.

What to watch now is whether the disruptions persist into the second half of the year, the threshold Bowman named, and whether the balance sheet debate moves from passing remark to real discussion with Warsh.