How energy prices figure into the Fed's interest rate decisions

The U.S. Federal Reserve’s Open Market Committee is meeting next week to make a decision about interest rates.

The meeting is happening at a time when energy prices have been volatile thanks to President Donald Trump’s war in Iran, and the conflict may weigh on the Fed’s upcoming decisions.

Menzie Chinn, an economics professor at the University of Wisconsin-Madison, said it’s a pretty safe bet that the Fed is keeping an eye on the war in Iran and its effect on energy prices.

“I think they will be eager to make sure that they show commitment to not let inflation get out of hand,” he said.

Chinn said the Fed usually focuses on core inflation, which strips out energy prices since they can jump around from month to month. But he said the Fed will also consider scenarios where the conflict drags on, keeping energy prices high for a while.

“And if it’s sustained, then that’s going to feed into core prices, eventually,” Chinn said.

That’s because the cost of energy can affect prices throughout the economy, said Claudia Sahm, chief economist for New Century Advisors.

“You think of something like airfares, which are in ‘core inflation,’” Sahm said. “But a really important piece of the cost structure for airlines is their fuel.”

Higher inflation could cause the Fed to eventually raise interest rates. But Sahm said the Fed will also consider what could happen if energy costs rise so high that the economy slows down.

“That’s a scenario in which the Fed would be stepping in and potentially cutting rates, even though those energy prices are higher, because it’s starting to create unemployment and really wreck growth,” she said.

Sahm said all the Fed can do, at this point, is gather as much data as it can to prepare for any of those outcomes.