Federal Reserve Faces Tough Decisions as Iran War Disrupts Economy

The Federal Reserve will meet this week to assess how the ongoing Iran conflict is affecting the U.S. economy through rising oil prices and supply disruptions. Officials must decide whether to focus on fighting inflation or supporting economic growth as gas prices have jumped 25% in two weeks.

WASHINGTON – Federal Reserve policymakers will gather this week to navigate the economic turbulence caused by the Iran conflict, which has disrupted roughly 20% of the world’s oil supply and created uncertainty about the path forward for interest rates.

The central bank faces a challenging balancing act as they determine whether the Middle East crisis will primarily harm economic expansion, fuel more stubborn price increases, or create a troublesome combination of slower growth alongside rising inflation.

Given how supply chain disruptions during the pandemic led the Fed to miss its 2% inflation goal for five consecutive years, central bankers are expected to adopt a more cautious or aggressive stance this week. Current inflation remains about one percentage point above their target and could climb further, especially if crude oil prices that surged nearly 50% over two weeks stay at elevated levels.

“A question that was almost unthinkable two weeks ago is now being more heavily debated: Could the Fed raise rates in 2026?” Matthew Luzzetti, chief U.S. economist for Deutsche Bank Securities, wrote last week. While some Fed officials were prepared to consider this possibility even at their previous meeting, Luzzetti determined rate hikes remain improbable without a clear spike in inflation expectations.

Central bankers must also evaluate whether the emerging economic disruption – expected to manifest through higher costs, stricter financial conditions, declining asset values and increased uncertainty – will finally break the economy’s remarkable durability.

“Just when it seemed the worst of the policy chaos was over, there is the Iran war to deal with,” Dario Perkins, chief economist for global macro at TS Lombard, wrote last week. He outlined the repeated challenges the economy has weathered from the pandemic through inflation and aggressive Fed rate increases, followed by tariff and immigration policy changes since President Donald Trump returned to office. “Our baseline assumption is that the conflict will be short-lived and ‘this too shall pass.’ But..could the energy crisis be one shock too many?”

Vulnerable areas include February’s job loss of 92,000 positions, middle and lower-income households already strained by expensive goods, and worries about tighter lending conditions, particularly if asset values continue dropping.

By Sunday, average U.S. gasoline prices had risen almost 25% to their highest point since October 2023 during the two weeks following U.S. and Israeli strikes on Iran, according to AAA data. This prompted American officials to predict the hostilities would conclude relatively quickly.

“I think that this conflict will certainly come to the end in the next few weeks – could be sooner than that. But the conflict will come to the end in the next few weeks, and we’ll see a rebound in supplies and a pushing down in prices after that,” U.S. Energy Secretary Chris Wright told ABC’s “This Week” program on Sunday.

The Fed is anticipated to maintain current interest rates during its Tuesday and Wednesday policy meeting. Information gathered since their last session revealed minimal changes to the fundamental economic picture, and the central bank is transitioning to new leadership under Kevin Warsh, Trump’s nominee who is expected to gain Senate approval to replace current Chair Jerome Powell after mid-May.

However, the latest economic data appears outdated following two weeks of intensive American and Israeli air campaigns and Iranian retaliation that have effectively blocked the crucial Strait of Hormuz. Trump has not established clear goals or a timeline for concluding the conflict.

Fed officials will nevertheless provide updated economic forecasts, making their best assessment of whether upcoming developments will demand a firm anti-inflation stance with continued restrictive monetary policy or rate reductions to counter economic weakness.

During the first Fed meeting after Russia’s Ukraine invasion in 2022, Powell outlined the considerations at hand.

The impact is “highly uncertain,” Powell said at the time. “In addition to the direct effects from higher global oil and commodity prices, the invasion and related events may restrain economic activity abroad and further disrupt supply chains—which would create spillovers to the U.S. economy through trade and other channels. The volatility in financial markets, particularly if sustained, could also act to tighten credit conditions and affect the real economy.”

The current situation presents even greater complexity, with the United States directly involved in combat and significant portions of global oil production and other goods unable to move through normal channels.

Some questions being raised are impossibly broad yet consequential, including whether rising Treasury yields indicate diminished U.S. standing in international markets, expectations of higher inflation, or other factors. Analysts are discussing various scenarios rather than making concrete predictions, with the “base case” typically assuming a brief conflict and eventually declining oil prices, while more harmful outcomes involve prolonged tensions between the U.S. and Iran.

Fed officials were caught off guard last year by how effectively the economy handled increased tariffs, labor market disruptions and an unpredictable environment under Trump. Throughout these challenges, U.S. economic output continued expanding even as job creation decelerated and inflation stayed above target levels.

Given present uncertainties, the simplest strategy may involve staying close to December’s projections, which showed a median prediction of just one rate reduction this year.

However, the range of individual forecasts may reveal important insights: Released after the Fed lowered rates by a quarter percentage point at the December meeting, six of 19 officials suggested rates should have remained higher. This hawkish sentiment intensified in January when meeting minutes showed several policymakers were prepared to consider rate increases this year, “reflecting the possibility that upward adjustments to the target range for the federal funds rate could be appropriate if inflation remains at above-target levels.”

Inflation worries have only grown since then, while concerns about economic growth and potential breaking points may also escalate – creating the most challenging scenario for central bankers to forecast or communicate effectively.

“The economic outlook has turned murkier as the conflict drags on and oil prices remain high and volatile,” Subadra Rajappa, head of research at Societe Generale, wrote last week. “While our base case continues to assume a timely resolution and no sustained economic fallout from this conflict…higher inflation and deteriorating labor market conditions make it difficult for the Fed to balance its dual mandate.”