Clouds of war shroud the economic outlook, and the Federal Reserve’s room for policy maneuvering may be greatly constrained.

The situation in the Middle East continues to escalate, fundamentally reshaping the Federal Reserve’s policy path. Soaring oil prices, rising inflation expectations, and a weakening labor market are occurring simultaneously, causing expectations for nominee Fed chair Waller to promptly cut interest rates after assuming office to fade significantly.

Brent crude prices have returned to above $100 per barrel, and retail gasoline prices have jumped to about $3.60 per gallon, more than 20% higher than before the conflict began. Meanwhile, the 30-year mortgage rate rose to 6.11% this week, with US Treasury yields climbing across the board. Expectations for Waller to cut rates at his first meeting have shifted from June further back, some forecasts postponed to December, while CME Group FedWatch data shows the next rate cut may not come until the end of 2027.

Waller is still pending Senate confirmation and is expected to take over from current chair Powell in May. However, inflation pressures brought by war, persistent pressure from Trump for immediate, substantial rate cuts, and the Federal Reserve's own credibility concerns are all putting the nominee in a web of contradictions, sharply narrowing his room for policy maneuver.

Oil price shock spreads throughout the economy

With the Strait of Hormuz still obstructed and regional oil and gas infrastructure shut down, oil prices have rebounded strongly even after strategic reserves were released in a coordinated manner by major developed countries. Rising energy prices are being passed downstream along the supply chain—from gasoline and diesel to airline ticket prices, and even potentially affecting food prices due to higher fertilizer costs.

Vincent Reinhart, chief economist at BNY Investments, pointed out that the Fed’s response will "depend on the size, scope, and duration of the oil price shock." He emphasized that rising energy costs have complex transmission channels in the economy, not only pushing up certain prices but also prompting consumers to cut back or shift spending and altering expectations for economic growth and employment.

Reinhart especially noted that the experience of surging inflation over the past five years to its highest level since the 1980s may have made the public’s inflation expectations more sensitive. "If expectations are not firmly anchored, it will show up more in rising inflation rather than hurting growth." He believes the Fed is still inclined towards rate cuts but "uncertainty is very high at the moment, so the appropriate policy is to hold steady and wait and see."

Next Week’s Fed Meeting: Hold Steady, Wording in Focus

Fed officials are expected to keep policy rates unchanged at 3.5% to 3.75% at next week’s meeting. Market focus will shift to the wording of the new statement, remarks at Powell’s press conference, and the latest economic forecasts, which for the first time will factor in the impact of war.

Officials face interpretive challenges beyond the Middle East situation. Tariff policy direction, immigration policy adjustments, and the impacts of recent regulatory and tax changes on businesses and households all present important uncertainties. Meanwhile, government statistics are lagged, and behavioral changes take time to appear in high-frequency data.

Michael Gunther, senior vice president at Consumer Edge, a consumer data tracking agency, said since the outbreak of conflict, credit card and debit card spending data show consumers may already be changing behavior—online orders have increased, and single transaction amounts at some stores have also risen, possibly to reduce travel frequency. But he stressed, "Since the conflict started on February 28, we have not seen any significant decline in consumer spending."

Inflation Data Remains Elevated, Rate Cut Window May Stay Closed All Year

The Fed’s preferred inflation gauge—the core Personal Consumption Expenditures (PCE) price index—rose 3.1% year over year in January, its highest since March 2024. Notably, this data does not yet reflect the impact of the energy price shock following the recent conflict, so subsequent inflation pressures may be even more pronounced.

Gregory Daco, chief economist at EY Parthenon, said he currently expects the Fed will not cut rates until at least December, and noted "it’s entirely possible the Fed doesn’t cut rates at all this year." This stance will put incoming chair Waller in direct conflict with Trump’s ongoing demands for immediate and aggressive rate cuts.

February jobs data is also alarming—nonfarm payrolls unexpectedly decreased by 92,000, highlighting concerns about a weakening labor market. Luke Tilley, chief economist at Wilmington Trust, noted that current employment growth is highly concentrated in the single sector of health care, “Historically, we have never seen such widespread job losses outside of health care without entering a recession.” He expects the Fed to maintain a hawkish tone at next week’s meeting, but also acknowledge downside risks to growth and ultimately start a rate-cut cycle within the year.

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