War in Iran Drives Up Interest Rates, Fed Rate Cuts Now Unlikely

Rising gas prices from the Iran conflict have pushed up long-term interest rates, making mortgages and loans more expensive. Wall Street now sees a 25% chance of Fed rate hikes by October, abandoning earlier expectations of rate cuts this year.

WASHINGTON — Escalating fuel costs tied to the Iran conflict have triggered another financial consequence that could hit American wallets: climbing interest rates.

Long-term borrowing costs have surged rapidly since fighting erupted on February 28, driving up expenses for home mortgages, car financing, and corporate loans. As inflation metrics are expected to climb in upcoming months, the possibility of Federal Reserve rate reductions in 2024 is diminishing. Market analysts now view potential rate increases as increasingly probable.

This shift toward considering rate hikes — though most economic experts still consider it unlikely — marks a dramatic reversal from earlier this year, when discussions centered on how frequently the Fed might lower its benchmark rate rather than whether cuts would occur.

“We think cuts are delayed, not derailed,” Krishna Guha, head of economics at Evercore ISI, an investment bank, wrote Tuesday. “The question is, delayed to September, delayed to December, or delayed more indefinitely” into 2027?

Chicago Federal Reserve Bank President Austan Goolsbee told The Associated Press on Monday that if price increases accelerate while joblessness stays steady, and consumers begin expecting sustained inflation, “then there is an obvious playbook, which is rate increases have to be on the table.” Though Goolsbee attends Fed policy meetings, he doesn’t hold voting privileges this year.

Market participants no longer anticipate any rate decreases in 2024, based on futures contracts monitored by CME Fedwatch. The likelihood of a rate increase by October has jumped to almost 25%, climbing from zero just seven days earlier.

San Francisco Fed President Mary Daly stated Monday evening that uncertainty from the Iran conflict means “there is no single most-likely path” for the Fed’s primary interest rate, indicating policymakers might raise, lower, or maintain current levels in coming months.

The military action presents a complex challenge for Federal Reserve officials. Economic analysts widely predict the crisis could intensify inflation through elevated fuel costs. However, when gasoline reaches very high levels — perhaps $5 per gallon for extended periods — consumers might reduce other purchases to compensate for increased fuel expenses, potentially slowing economic activity and raising joblessness.

“On net more inflation means probably higher rates,” said Jonathan Pingle, an economist at UBS. “On the other hand, that energy price shock is going to be a headwind to growth.”

The Federal Reserve traditionally increases rates — or maintains current levels — when fighting inflation, while frequently reducing rates to stimulate economic activity and decrease unemployment.

Central banks typically ignore temporary inflation spikes from fuel price jumps, since these effects often prove short-lived. Under such circumstances, the Fed might even lower rates if officials became concerned about rising joblessness.

However, Fed Chairman Jerome Powell noted at last week’s press briefing that assuming temporary effects is more difficult currently, given that inflation has exceeded the 2% goal for five years, damaging public confidence in economic conditions.

Currently, numerous Fed policymakers emphasize inflation risks, suggesting the central bank will maintain its key rate at present levels in upcoming months. UBS economists project inflation, using the Fed’s preferred measurement, will rise to 3.4% this month and reach 3% by year-end, surpassing the 2% target.

The jobless rate “is kind of low and stable,” Goolsbee said. “So that isn’t as far from the target as inflation is right now. And now to pile on a second inflation shock makes me a bit more concerned on the inflation side than on the unemployment side right now.”

When market participants expect the Fed to keep short-term rates elevated longer, longer-term rates climb. The 10-year Treasury yield has risen from just under 4% on February 27, one day before Iran fighting began, to nearly 4.4% Wednesday.

Home loan rates follow the 10-year Treasury closely, with 30-year fixed mortgages now averaging 6.22% according to Freddie Mac, climbing from below 6% before the conflict started.