Oil-driven inflation surge raises odds Fed keeps rates elevated

WASHINGTON (TNND) — Elevated inflation that came in hotter than anticipated is reinforcing expectations the Federal Reserve will keep interest rates steady and may even force policymakers to consider hiking rates if price pressures spread through the economy.

Much of the latest inflation surge is being driven by higher energy prices due to the war with Iran, which has disrupted global oil markets and complicated the central bank’s path forward.

The U.S.-Israeli war with Iran has driven up energy prices around the world with traffic through the Strait of Hormuz at a standstill. Prior to the war, around 20% of the global oil and natural gas supplies passed through the narrow waterway.

But Tehran’s threats to fire on tankers that try to pass through the strait and a U.S. naval blockade on the Strait have strangled oil supplies, pushing the cost of Brent crude above $100 a barrel.

Higher energy prices push up costs for manufacturers who use oil and natural gas to power their facilities and use them as materials for a wide range of products. It has also increased costs for gasoline and diesel, making shipping their products more expensive and adding another pressure on prices.

Back-to-back reports on inflation have put concerns about runaway prices into overdrive. The consumer price index released on Tuesday hit a nearly three-year high at 3.8% in April. On Wednesday, new data on wholesale inflation showed producer prices rose 6% from a year ago, the most since December 2022.

The producer price report suggested inflationary pressures are becoming less confined to energy.

Energy prices jumped 7.8% in the producer index for April after a 10.1% spike in March, but price increases weren’t contained to energy. The “core” reading, which strips out energy and other volatile categories, also climbed 4.4% from the year prior and 0.6% from March. Those increases signal inflationary pressures are working throughout the supply chain.

Central banks tend to look through oil shocks from global conflicts with the expectation prices will normalize once they’re over. But the current price shocks are coming after more than five consecutive years of inflation running above the Fed’s target of 2% and on top of Trump’s sweeping use of tariffs.

“It just points to this trend of inflation increasing, and in that, it’s becoming more embedded in our economy — so it’s not a short-term phenomenon, but a long-term one,” said Mark Williams, a finance lecturer at Boston University’s Questrom School of Business and former bank examiner at the Fed. “As inflation gets embedded, it’s very hard for the Fed to actually extract it.”

Producer prices are closely watched by economists because they provide an early look into how costs are filtering through the supply chain and offer an early indicator in price hikes coming to consumers.

The hotter-than-expected inflation readings are likely to reinforce the central bank’s opposition to cutting rates in the near term. They are also likely to reinforce the views of officials who want to change the Fed’s policy statement away from any suggestions it is leaning toward cutting.

Wall Street has become increasingly anxious about inflation becoming sticky with markets essentially pricing out any chance of a rate cut off the table between now and the end of 2027, according to CME’s FedWatch tool. Markets are pricing in another hold at the next Fed meeting in June as a near-certainty and a 30% chance of a hike in December.

It comes as the Fed is preparing for a leadership transition.

The central bank will have a new chair by the time it makes its next decision on rates in June. Kevin Warsh, a former Fed governor nominated to replace Powell, is stepping into a challenging environment for policymakers with elevated inflation, sluggish job growth and an unpredictable conflict in the Middle East.

He will take over an FOMC that was already hawkish toward inflation and has become more skeptical of additional rate cuts the president has persistently called for since returning to office.

It will also include Powell, who is the first chair who opted to stay on as governor since 1948. Powell has promised to keep a low profile on the FOMC, but his continued presence could help other Fed officials who are wary cutting rates more latitude to push back.

Warsh is facing a delicate balance of maintaining his credibility to financial markets and other Fed governors while also avoiding backlash from the White House. He has recently advocated for lowering interest rates to bolster the economy and labor market but did not offer much about the direction he would like to move in during his Senate confirmation hearing but vowed to be independent from the White House.

“I don’t think he changes the Fed’s wait-and-see stance. That wait-and-see stance is extremely important because of the uncertainty the war has created in the pricing structures being created around the globe,” Williams said.