The bond market is helping resolve the Fed's interest rate dilemma

The bond market may be doing the Fed’s work for it.

The central bank is looking to hold rates steady in the face of the conflict in Iran, which has sent oil prices spiking more than 50% and raised expectations of higher inflation in the next few months.

Meanwhile, markets have already priced in a rate hike. In the first month of the war, global short- and long-term government bond yields have risen significantly, as bond markets have been repricing them to reflect the rapidly changing outlook for higher inflation.

“The unprecedented oil-supply shock caused by war in the Middle East has crushed investors’ former expectations for subdued inflation and dovish central banks’ actions,” Ed Yardeni, president and chief investment strategist of Yardeni Research, wrote in a research note.

Read more: How oil price shocks ripple through your wallet, from gas to groceries

Fed Chair Jerome Powell said this week that the central bank has traditionally looked through oil price shocks and not taken action, but policymakers can’t ignore that the increase in oil prices comes amid inflation that has remained above the Fed’s 2% goal for five years now.

At least one Fed member is suggesting the Fed shouldn’t look through the oil price shock. “With inflation already running hot, now is not the time to assume that the inflation from higher oil prices will be transitory,” Kansas City Fed president Jeff Schmid said in a speech Tuesday.

A critical task for the Fed is carefully monitoring inflation expectations and whether a series of inflation spikes from the pandemic, tariffs, and now oil could lead the public generally — businesses, price setters, and households — to start expecting higher inflation over time.

Read more: How jobs, inflation, and the Fed are all related

“We’re very mindful of that fact,” Powell said on Monday. “Inflation expectations do appear to be well anchored beyond the short term, but nonetheless, it’s something, as we will eventually maybe face the question of what to do here.”

If longer-term inflation expectations rise above the 2% target, the Fed would need to move.

But it may not have to. The central bank raises and lowers its benchmark interest rate — the rate at which banks lend to each other overnight, which, in turn, influences all the other interest rates in the financial system to loosen or tighten borrowing costs. The cascade effect of lower rates boosts economic growth, while higher rates rein it in.

Right now, the yield on the two-year Treasury — the best barometer of where investors think the federal funds rate is heading — has risen to 3.8% and was as high as 4% on March 27, compared with 3.4% before the war began on Feb. 28. That’s above the current range of the federal funds rate of 3.5% to 3.75%.

Read more: What is the 10-year Treasury note, and how does it affect your finances?

The yield on the 10-year Treasury has risen from about 3.96% to as high as 4.4%, breaking through the key 4.25% ceiling of the trading range seen since last August.

The 10-year Treasury rate affects 30-year fixed mortgage rates, which have risen more than a half-point on average since reaching three-year lows just three weeks ago. According to the Zillow lender marketplace, the national average 30-year fixed mortgage rate is 6.47%.

“The trend, unfortunately, is not the consumer’s friend right now,” Bankrate senior economic analyst Mark Hamrick said, noting that mortgage rates in the “mid-6s” are now the reality for many homebuyers, and other types of debt, like auto loans and credit cards, are similarly elevated.

“Consumers hoping for relief on high-interest revolving debt will have to wait longer, as the Fed’s further easing is now on hold due to the Iran-related energy shock,” Hamrick said.

Before the conflict, the bond market was pricing in two to three 25 basis point rate cuts this year. A week ago, all those rate cuts were off the table, and there was a 40% probability of a hike in October. As of Tuesday, the market is not pricing in any rate cuts this year, per CME Futures.

At the Fed’s policy meeting a few weeks ago, officials still saw the prospect of one rate cut this year. But Powell warned not to put too much stock in the interest rate projections and noted that, overall, most Fed members had penciled in fewer cuts since December.

The possibility that the Fed’s next move might be a rate hike also came up at the meeting, as it did at the January meeting, according to Powell. He said the vast majority of Fed officials don’t see that as their base case but that it’s not off the table.

Read more: How the Fed rate decision affects your bank accounts, loans, credit cards, and investments

The central bank now expects inflation on a headline and “core” basis, which excludes volatile energy and food prices, to rise to 2.7%, up from a previous forecast of 2.5% for the year.

New York Fed president John Williams, who is vice chair of the Federal Open Market Committee and holds a permanent seat, said Monday that he expects the spike in oil prices to boost overall inflation in the coming months but that the effects should partially reverse later this year, assuming oil prices come down after hostilities cease.

He also noted that the war itself could push inflation higher through surges in intermediate costs and commodity prices and dampen economic growth.

Markets are also concerned about growth. The yield curve — the difference between yields on short-term government bonds and long-term government bonds that signal how markets perceive the direction of economic growth — has flattened.

“That happens when there is a concern about growth,” said Wil Stith, senior bond portfolio manager for Wilmington Trust. “If oil stays elevated and increases in price, you’re going to start to see demand destruction.”

Stith characterized the bond market’s reaction as “measured,” noting that the focus is on inflation, inflation expectations, and perhaps a slower economy, specifically greater concern about unemployment.

A strong February employment report, due out Friday, could send the yield on the two-year Treasury back up to 4%. But a weaker report could mean it trades with a yield closer to 3.6%.

“It’s a wait-and-see as to how long this conflict lasts,” Stith said. “It’s a wait-and-see and how much this conflict affects US inflation.”

Yardeni maintained that the US economy is more vulnerable to an oil shock today than in 2022. Yardeni noted that after Russia’s 2022 invasion of Ukraine, which sent oil prices as high as $145 per barrel, pandemic-era stimulus was still circulating through the economy, the labor market was historically strong, wage growth was robust, and consumer confidence was high.

Today, low- and middle-income households are under pressure, and labor market conditions have cooled substantially.

“In this environment, a sustained negative oil-supply shock becomes recessionary faster,” Yardeni said. “It takes less elevated oil prices to trigger demand destruction. In this scenario, the Fed’s reaction should be to do nothing.”

Jennifer Schonberger is a veteran financial journalist covering markets, the economy, and investing. At Yahoo Finance she covers the Federal Reserve, Congress, the White House, the Treasury, the SEC, the economy, cryptocurrencies, and the intersection of Washington policy with finance. Follow her on X @Jenniferisms and on Instagram.

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