– After Rate Hike Odds Rose, Improved Prospect of Disinflation Causes Rethinking
By Steven K. Beckner
(MaceNews) – Over the course of Kevin Warsh’s first week as Federal Reserve chairman, Fed officials have been trying to factor a rapidly changing Middle East and oil market picture into their monetary policy calculations. It hasn’t been easy or uniform or predictable.
During a very active week that saw a dozen Fed officials make public comments about the economy and monetary policy, what emerged was a loose consensus that there is no need to change rate settings in the short term, but their longer run thoughts are a melange of uncertainty, division, and conditionality.
Complicating always tricky Fed forecasting and projecting exercises ahead of the June 16-17 meeting of the Fed’s policymaking Federal Open Market Committee has been the Iran war and its disruption of global energy trade and resultant spike in energy costs that took oil to $126 per barrel in late April.
This week began with high hopes for a deal with Iran that led to a sharp drop in oil prices. Those hopes soon gave way to disappointment amid renewed clashes between U.S. forces and elements of the Iranian Revolutionary Guard. But Thursday evening brought word that negotiators had reached a “memorandum of understanding” to extend a ceasefire between the U.S. and Iran for 60-days, pending President Trump’s approval.
Already, the price of oil has fallen to below $87 for light sweet crude, and the decline is expected to continue, pulling the price of gasoline down with it. If that occurs, it could make an enormous difference on not just the inflation readings which have been bedeviling the Fed for the past few months but also on the Fed’s own inflation outlook.
Fed officials have been trying to make sense of it all and how it might affect the FOMC’s decision making in June and beyond.
It’s not often that diplomacy exerts a major influence on monetary policy, but the Fed could be on the verge of a dramatic exception. This week brought events so consequential that they could have far-reaching effects in the central banking world in the months ahead, depending on how things play out.
Conceivably, a continued downtrend in oil prices that provided broader relief on inflation might enable Warsh to steer the FOMC back toward monetary easing eventually.
Certainly that’s what the White House is hoping for. Early in the week, Trump’s chief economic adviser Kevin Hassett stated, “we expect energy prices, as soon as there’s a deal, to plummet, and when that happens, then there will be a lot of room for the Fed to do the right thing at lower rates.”
That is way premature at this juncture, in the dominant Fed view, but the mood does seem to be changing.
Last week rate hike odds had increased in financial markets, and sentiment among Fed officials was moving in the same direction. Before the ostensible Iran breakthrough, even Gov. Christopher Waller, who dissented in favor of a fourth rate cut at the Jan. 28 FOMC meeting, was singing a very different tune. Not only did he downgrade the possibility of rate cuts, he provisionally expressed willingness to back rate hikes.
This week, however, more doubts about the appropriate course of monetary policy thinking have crept into Fed thinking, as evidenced by comments from Governors Lisa Cook and Phillip Jefferson and from Federal Reserve Bank Presidents – New York’s John Williams; Dallas’s Lorie Logan; St. Louis’s Alberto Musalem and San Francisco’s May Daly.
For the time being, policymakers are still in the process of adjusting to the run-up in energy costs and weren’t quite ready to pivot to a world of plummeting oil prices, but in many cases they acknowledged that a highly uncertain future could evolve in very different ways with divergent policy implications.
Cook and others have called monetary policy “well positioned,” using a term first uttered by former Fed Chairman Jerome Powell. That seeming neutrality sometimes masked a bias toward tightening, but as oil plunged, many seemed to take the edge off that bias, and officials seemed increasingly willing to consider the possibility that a resumption of rate cuts might become appropriate.
But few are prepared to make hard and fast choices about which direction policy will ultimately need to take. While some lean one way or another, others are more ambivalent.
Some were taking an alternative scenarios approach.
Daly said Friday that the proper path of policy will depend heavily on when the war actually ends; what happens to oil prices, and in turn what happens to inflation. If inflation continues to accelerate, the FOMC would have no choice but to “get ahead of it,” she said. But, with a hopeful eye on oil futures, she said the FOMC could “do less” if inflation moderates.
Musalem said the day before that he could envision situations where the Fed might need to raise rates, but also ones in which it might want to cut them.
A closely related topic that has been much discussed in Fed circles lately (not as hot as Iran) has been productivity and the widespread belief that AI investment is increasing the growth of output per hour, which in turn has led to competing theories about the implications of faster productivity growth for monetary policy.
Some, including Warsh in the past, have contended that faster productivity growth should enable the Fed to lower interest rates, or at least refrain from raising them, as Alan Greenspan famously did in the 1990s. Others, notably Goolsbee and Musalem, argue just the opposite – that the Fed may need to raise rates to keep anticipated wealth gains from fueling more consumption and causing the economy to “overheat.”
At its last meeting, April 28-29, the FOMC left the funds rate in a target range of 3.5% to 3.75% on April 29. But there were an unusual four dissents, with soon-to-depart Governor Stephen Miran wanting an immediate rate cut and three Federal Reserve Bank presidents wanting to ditch the easing bias contained in the “forward guidance” paragraph of the FOMC statement.
The majority voted to retain this sentence: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.” By referring to “additional adjustments,” as it had following the last of three rate cuts on Dec. 10, the FOMC leaned toward a resumption of rate cuts at some point.
Only Cleveland Fed President Beth Hammack, Minneapolis Fed President Neel Kashkari and Dallas Fed President Lorie Logan voted to drop that “easing bias.” But minutes of the last FOMC meeting revealed that “many participants” wanted to drop the easing bias. And they showed a definite shift in sentiment in the direction of tighter policy by reporting that “a majority of participants highlighted …. that some policy firming would likely become appropriate if inflation were to continue to run persistently above 2%.”
Hawkish noises didn’t completely disappear this week, but officials sounded less eager to raise rates and more willing to consider other options. On net, their comments seemed to signal an extended “pause” at current rate levels.
Fed Vice Chair for Supervision Michelle Bowman has been quiet about monetary policy lately, but on Friday she renewed her case for not making policy any more restrictive than it already is and for returning to easing down the road.
“I am optimistic that, once the conflict is resolved, supply disruptions will ease, leaving a temporary imprint in PCE inflation and minimal impacts on domestic economic activity,” she told an Economic Conference in Reykjavík, Iceland. “This view seems consistent with oil futures prices and with financial market optimism.”
Not only is inflation likely to subside, but there are “signs of fragility” and “signs of labor market softening,” Bowman warned.
She didn’t rule out a need for tighter policy if the Iran conflict and in turn the oil price spike persists, but for now said “it is appropriate to look through temporarily elevated inflation readings largely due to higher energy prices…”
And she cautioned, “in response to temporary adverse energy supply shocks, policy should not be overly aggressive at stabilizing total inflation to keep employment close to our maximum-employment goal. Reacting to temporarily elevated energy price inflation would add unwarranted policy restraint, weighing unnecessarily on economic activity and labor market conditions.”
Daly, usually thought of as more mainstream, sounded just as hopeful about inflation as Bowman in a Fox Business appearance Friday, making multiple references to the decline in oil futures prices.
“I see that there’s no urgency to make an adjustment,” she said. “Policy is in a good place. We can respond as we learn more about the economy.”
Daly said “there’s a lot of uncertainty. When does the conflict end? When do oil prices come back (down)?”
But she added that “futures markets still think they’re coming back, and that’s a good thing.”
Daly said that “right now it’s all about restoring price stability and doing that without taking the momentum from the economy and from the labor market.”
Asked about what the FOMC needs to do to bring inflation down to an acceptable level, she replied, “It’s less about the level, and more about the direction of change. If we think inflation is going to consistently go up then we definitely have to get ahead of that. But if we think it’s going to move through – that it’s related to oil prices and oil prices are going to come down as the futures market suggests — well then you have to do less.”
“So it’s really not about looking at today or backward looking information, but about looking at tomorrow, and what’s going to happen going forward,” Daly went on. “So for that we need to know when the war ends and how oil prices behave afterward.”
She said “two pieces of information are going to be really important: how long will the conflict last and oil prices remain elevated.”
“Right now, futures prices look good on oil,” Daly repeated. “But at some point , if those drift up because the conflict has persisted, well then that would change my mind on the outlook for the economy in terms of inflation.”
She said she also wants to see “how much does (the bulge in energy costs) spread to other things,” but said, “Right now, we’re not seeing it spreading into service industries. We’re not seeing a lot of pass-through of costs on to consumers except for specific industries where fuel is a big component of the overall business.”
“If it starts to spread, that would be something to watch,” Daly added.
Philadelphia Fed President Anna Paulson said Friday she does not see any “structural” changes in inflation — just transitory shocks.
The FOMC voter, who voted to retain the easing bias at the late April meeting, allowed for rate hikes in previously delivered remarks to the Chamber of Commerce Southern New Jersey.
But Paulson said that “if the conflict in the Middle East is resolved soon and shipping and oil production return to normal quickly, inflation and inflation risks are likely to subside relatively quickly.”
“If it takes more time to resolve, inflation and inflation risks, along with risks to the labor market, are likely to be elevated for long,” she added.
Kansas City Fed President Jeff Schmid took his usual somewhat more hawkish stance Friday in remarks to the Bank of Iceland conference in Reykjavik.
“Textbooks suggest that central bankers should “look through” such price changes,” he said. “But there is also a realization that inflation can become embedded and persistent.”
“With inflation running above the Fed’s 2^t definition of price stability for over five years, now is not the time to let down our guard,” Schmid continued. “We must continue to signal our commitment to price stability and our willingness to take the actions necessary to achieve our mandate.
FOMC Vice Chairman John Williams leaned toward neither rate hikes nor rate cuts in Reykjavík Thursday. “Right now, monetary policy for the Fed is, is right where we want it to be,” Williams said at the Reykjavík Economic Conference in Iceland.
He called current Fed policy “slightly restrictive” and said, “taking a longer view…we are well positioned to continue to learn what happens with the conflict, with other data, before we need to make a decision” on changing rates.
Significantly, Williams was hopeful that disinflation will resume. “I think in the next few months we’re going to see, continue to see very elevated inflation with (personal consumption expenditures) inflation around close to four, around 4%, core inflation above 3% like we’re seeing today.”
But he added that, as the tariff and oil price shocks fade, inflation should decelerate.
Musalem, who has a fairly hawkish reputation, lived up to it Thursday when he expressed a strong tilt toward upside inflation risks. While not ready to raise rates yet, he saw that as more likely than rate cuts.
“We were having a little bit of a rise in infl even before the war began, and we have an economy that so far has been robust, and we have a labor market that has the unemployment rate around its natural rate; so on the real side things seem to be okay,” he said in response to questions at the conference in Reykjavík.
“When we look at demand pressures from AI they are very real, and we have to talk about those and not talk only about the supply side of the economy, Musalem added.
What’s more, he said, “the real policy rate (the nominal federal funds rate minus inflation) is below where the Committee believes the long run rate is,” he went on. “So my baseline outlook is that inflation will take longer to come back down to target…the real rate is below 1%. So I see risks that inflation may not converge to target as we would like.”
Musalem, a non-voter this year, proceeded to outline two scenarios – one in which a rate hike would be called for, another in which rate cut might be justified.
“I think there is a scenario where the economy might require a rate increase,” he said, asking “What does that scenario look like?”
“It looks like disinflation not reasserting itself in the next … one to two quarters,” Musalem elaborated. “So if we don’t see disinflation in the next one to two quarters that would concern me. If I see inflation expectations continue to drift higher or remain elevated that would concern me. If I see a labor market that remains robust, that would tell me that the risks have really shifted and tilted towards inflation, not so much toward the real economy.”
He also outlined a potential easing scenario, “where after the fiscal stimulus that is now going through the pipeline, after that phase in the second half of the year, or towards the second half of the year, and after consumers and businesses go through six moths of real income squeezes or real profit margin squeezes, we could see a slowdown in growth, and we could see the labor market cool some more.”
“If that were to happen, and if inflation begins to fall because the impact of energy prices falls off … and/or if the tariff impact fades, then you could say, ‘well, we are back on our disinflationary trend, there is more risk on the real side of the economy,’ and you could envision rate cuts.”
“But,” Musalem was quick to add, “right now my view is that the risks have tilted more toward the inflation side than to the labor market side.”
Earlier, in his prepared remarks, echoed Goolsbee and others in throwing cold water on the notion that faster productivity will be anti-inflationary.
“With the real policy rate sitting below the FOMC’s notion of long-run neutral, inflation running meaningfully above target, longer-term inflation expectations drifting higher and the labor market remaining stable, I believe it would be risky to rely on the prospect of higher productivity growth in the future to solve our inflation problem today,” he told the Reykjavik audience.
“I’m prepared to adjust my position if the evidence becomes clear that higher productivity growth is pushing inflation lower to target,” Musalem continued. “But for now, I believe a vigilant focus on returning inflation to target will best ensure success in achieving both maximum employment and price stability for the American people.”
He conceded that “in theory, by lifting productivity growth, AI could help reduce inflation, allowing the Fed and other central banks to lower interest rates,” because “ higher productivity directly reduces production costs.”
However, Musalem cautioned, “on the demand side, the expectation of rising income in the future can stimulate spending and investment, driving up labor demand and wages….”
“(I)f the realized increase in productivity is persistent, then the demand response is
larger and longer-lasting, potentially to the point of overwhelming the supply-side cost relief.” he further explained. “The result could be higher marginal costs and upward pressure on inflation and interest rates. The prospect of persistently high future income and productivity of capital raises the natural rate of interest. Households want to borrow and firms want to invest, putting upward pressure on real rates.”
Musalem warned, “When productivity growth increases are persistent, avoiding higher inflation typically means the central bank must address the higher real interest rate by raising the nominal policy rate….”
If the Fed were to instead lower rates in the belief that better productivity will reduce inflation, he said “doing so could be counterproductive, resulting in higher inflation in the future as well as in the present, regardless of whether higher productivity growth materializes.”
“A better policy would be to lean against demand and inflation pressures today,” Musalem said. What’s more, the Fed needs to mind inflation expectations, which he noted “have been creeping higher,”
“In this environment, if central bankers tolerate higher inflation today based on the hope of lower inflation in the future, the people we serve may lose confidence in our commitment to see inflation return to target….,” Musalem warned, adding that “If the public begins to question whether inflation will ever fall back to target, market participants are likely to demand higher interest rates to compensate for higher expected inflation and inflation risk.”
He concluded that “caution seems warranted in the face of upward inflation pressures from both supply and demand forces…..(A)t present, I believe we should keep our guard up against persistent above-target inflation today, rather than base monetary policy on the hope that we will have higher productivity growth tomorrow.”
Much the same position was taken Wednesday by Chicago Fed President Austan, Goolsbee, who said the U.S. and other economies have been hit by a “stagflationary shock” caused by the oil spike.
Goolsbee said that if inflation subsides interest rates could “ultimately settle at some place well below where they are today.”
But for now, the Fed must be on guard against inflation. Even faster productivityi growth, which some have portrayed as an inflation-curbing force, could backfire on the Fed and force it to tighten monetary policy, he said.
“My concern is that future increases in productivity that make us rich may fuel high equity prices that they are a increase in your wealth today, to know that you’re going to be rich sometime in the future,” said Goolsbee, who was also at a Bank of Japan conference in Tokyo .
Fed Vice Chairman Phillip Jefferson was more even-handed than others in Wednesday remarks to the BOJ conference, saying that “the rise in crude oil prices poses downside risks to growth and upside risks to inflation around the globe.”
He said the Fed’s current policy stance “leaves us well positioned to respond to economic developments based on the incoming data, the evolving outlook, and the balance of risks.” But he added, “I have not prejudged the next meeting and look forward to engaging with my colleagues about the policy necessary to best achieve our dual-mandate goals.”
While rising oil and gas prices have obviously pushed headline inflation higher, Jefferson said he is also “watching whether higher energy prices will start to weigh on consumer spending.”
Despite oil and tariff shocks, Jefferson said “recent economic growth in the U.S. has been solid, though I expect a more modest pace of growth this year as households face high energy costs. The U.S. labor market is broadly stable, with both hiring and firing at relatively low levels.”
He “see(s) risks to the labor market as somewhat skewed to the downside.”
On the other side of the dual mandate, “disinflation in the U.S. stalled over the preceding year, largely because of increased tariffs,” Jefferson lamented, noting that “in recent months, inflation moved notably higher because of higher energy costs.”
“I expect inflation to decline later this year as the effects of tariffs and the energy shock wane, but I view risks around my inflation outlook as tilted to the upside,” he added.
Gov. Cook also indicated she is content with the current policy stance Wednesday, but was less shy than Jefferson about her future policy leanings.
She said she “currently believe(s) that the right course of action is to hold rates steady,” but said she is “prepared to raise rates, if the expected disinflation does not appear in a timely manner.”
While she cited “elevated risks to both sides of our mandate,” and while she said she is also “prepared to adjust my policy stance downward should the labor market deteriorate,” Cook made clear her main concern is inflation in Wednesday afternoon remarks at Stanford University.
In effect, the main thrust of her comments suggested Cook has her own tightening bias.
“Inflation is clearly moving in the wrong direction,” she said, noting that even excluding energy and food, “core PCE inflation is estimated to have risen by 3.3% over the 12 months ending in April—its highest reading since 2023.”
Cook said “inflation has been pushed up by shocks that should, in theory, be temporary and short lived” and said tariff effects “should begin to abate soon.” But she said “the path of energy prices is tied to the ongoing conflict, the results of which are highly uncertain.”
She acknowledged that “most forecasters and market participants….expect that oil and gasoline prices should decline, to some extent, by the end of the year.” But she warned, “even temporary and short-lived shocks could influence inflation over the medium term.”
“Firms may embed these shocks into their pricing decisions, and workers may incorporate them into wage negotiations,” Cook continued. “Moreover, yet another shock to prices could be layered on from the heightened investment demand due to AI….”
She also expressed concern that energy cost pressures could push up inflation expectations and said that is something she and her Fed colleagues are “watching very carefully” to make sure higher prices for fuel and other things don’t “get embedded” in wage and price-setting behavior.
Cook was more sanguine about the Fed’s “maximum employment” mandate, saying, “In contrast to inflation, the labor market appears to be largely stable.”
She said she does “view the downside risks to the labor market as being elevated,” in par t because “heightened uncertainty about output due to the Middle East conflict. A softening in demand could lead to a softening in the labor market.”
But Cook said she is “optimistic” about economic growth and in turn jobs.
Minneapolis Fed President Neel Kashkari, one of the Fed presidents who dissented against keeping the easing bias on April 29, said Wednesday that the Fed has to focus on inflation, given the “inflationary shockwave” from the Middle East, coming on top of “elevated inflation for five years.
But, while he reiterated his preference for ditching the easing bias in favor of “neutral” forward guidance, he withheld judgment on whether or when the FOMC needs to move to monetary tightening.
“We need to see just what happens (with the Iran war),” Kashkari told a Bank of Japan conference in Tokyo. “Negotiations are taking place and headlines are coming out every day. We have to see where those ultimately go.”
Financial markets have begun to price in an October rate hike, but Kashkari commented that “it’s far too soon for me to make such a prediction about when the next move would be. I want to see what happens in those negotiations and see how global supply chains are responding.”
Dallas Fed President Lorie Logan, another of those dissenters against keeping the easing bias, did not directly address the issue of whether monetary policy needs to be tightened at the BOJ conference, focusing instead on the economic impact of oil supply disruptions. But, though she forecast weaker energy consumption, she did not say the Fed should act to offset lower demand by holding interest rates down.
Drawing on her sources in her oil-rich Eleventh District, she said “industry leaders see little scope to increase oil production outside the Persian Gulf in the near term” to make up for the shortfall of oil caused by the closure of the Strait of Hormuz, which she estimated at “nearly 13 million barrels per day.”
She said the Dallas Fed’s latest survey of energy executives showed an anticipated increase in output of “no more than 250,000 barrels per day by the end of 2026 and 500,000 barrels per day in 2027.” She attributed this “constrained response” to producers’ “strict capital discipline”; “tight supplies of labor and other inputs,” and “little pipeline capacity to move more gas out of the fields in West Texas.”
“With supplies highly constrained, if shipping through the strait does not soon return to prewar levels, world oil and natural gas consumption could need to fall more meaningfully than it has so far,” Logan said, adding that “the economic consequences would depend on the degree to which end users can switch to other energy sources or use energy more efficiently, versus curtailing economic activity.”
“One way or another,” she “expect(s) energy markets to come into rough balance before too long.”