WASHINGTON, March 16 (Reuters) - U.S. Federal Reserve officials, their policy outlook roiled by a war that has stranded a fifth of global oil supply, meet this week to debate whether the Iran conflict is more likely to disrupt economic growth, threaten more persistent inflation, or create a confounding mix of economic slowing and rising prices.
Mindful of how pandemic-era supply shocks put the Fed on a path to miss its 2% inflation target for five years running, policymakers are more likely to strike
a cautious if not outright hawkish tone this week. Inflation is mired about a percentage point above target and is poised to move higher, particularly if oil prices that jumped almost 50% in two weeks remain elevated.
"A question that was almost unthinkable two weeks ago is now being more heavily debated: Could the Fed raise rates in 2026?," Matthew Luzzetti, chief U.S. economist for Deutsche Bank Securities, wrote last week. It's a possibility some Fed policymakers were ready to put on the table even at their last meeting, though Luzzetti concluded rate increases still were unlikely, absent a clear jump in inflation expectations.
Officials will also have to weigh whether the developing economic shock, expected to show up not just in higher prices but also in tighter financial conditions, lower asset prices and more uncertainty, will be the factor that breaks the economy's resilience.
"Just when it seemed the worst of the policy chaos was over, there is the Iran war to deal with," Dario Perkins, chief economist for global macro at TS Lombard, wrote last week. He recounted the repeated stress the economy has navigated from the pandemic to the inflation and rapid Fed rate hikes that followed and then the tariff, immigration and other policy shifts since President Donald Trump's return to office. "Our baseline assumption is that the conflict will be short-lived and 'this too shall pass.' But..could the energy crisis be one shock too many?"
Potential faultlines include February's loss of 92,000 jobs, middle- and lower-income consumers already stretched by high prices and concerns about credit tightening, particularly if asset prices keep declining.
As of Sunday, the average U.S. retail gasoline price had climbed nearly 25% to the highest since October 2023 in the two weeks since the U.S. and Israel launched attacks on Iran, according to AAA, prompting U.S. officials to predict hostilities would end sooner than later.
"I think that this conflict will certainly come to the end in the next few weeks - could be sooner than that. But the conflict will come to the end in the next few weeks, and we'll see a rebound in supplies and a pushing down in prices after that," U.S. Energy Secretary Chris Wright told ABC's "This Week" program on Sunday.
PROJECTING THROUGH FOG OF WAR
The Fed is expected to hold interest rates steady at its policy meeting on Tuesday and Wednesday. Data since the last meeting showed little change in the underlying outlook, and the Fed is transitioning to a new leader, Kevin Warsh, nominated by Trump and expected to eventually win Senate confirmation to take over from current Chair Jerome Powell after mid-May.
The most recent data, however, seems almost ancient two weeks after the start of intense U.S. and Israeli airstrikes and Iranian counterattacks that have all but closed the strategic Strait of Hormuz. At this point Trump has set out no clear set of objectives or timeline for ending the war.
Fed officials, however, will still submit new economic projections, making their best guess about whether what's about to play out will require a firm stand against inflation with continued tight monetary policy or rate cuts to offset an economic slowdown.
In the first Fed meeting following Russia's invasion of Ukraine in 2022, Powell walked through the list of issues to consider.
The impact is "highly uncertain," Powell said at the time. "In addition to the direct effects from higher global oil and commodity prices, the invasion and related events may restrain economic activity abroad and further disrupt supply chains—which would create spillovers to the U.S. economy through trade and other channels. The volatility in financial markets, particularly if sustained, could also act to tighten credit conditions and affect the real economy."
'OUTLOOK HAS TURNED MURKIER'
The situation now is even more dynamic, with the U.S. a combatant and a large share of global oil production and other products unable to move.
Some issues being raised are imponderably broad if consequential, such as whether the rise in Treasury yields shows a loss of U.S. privilege in global markets, an expectation of higher inflation or something else. Analysts are not so much making forecasts as discussing different scenarios, with the "base case" usually involving a short-lived conflict and eventually falling oil prices, and more damaging outcomes involving an extended standoff between the U.S. and Iran.
Fed officials were surprised last year at how well the economy absorbed higher tariffs, labor market disruptions and an unpredictable environment under Trump. Through all of that U.S. output kept growing even as job creation slowed and inflation remained lodged above target.
Given current uncertainty, the easiest approach now may be to stay close to December's outlook, which showed a median forecast of just one rate cut this year.
But the spread among individual forecasts may itself tell a tale: Issued after the Fed cut rates by a quarter percentage point at the December meeting, six of 19 officials indicated rates should have stayed higher. The hawkishness turned up another notch in January when minutes of that meeting showed several policymakers were ready to open the door to rate hikes this year, "reflecting the possibility that upward adjustments to the target range for the federal funds rate could be appropriate if inflation remains at above-target levels."
Inflation concerns have only been stoked higher since, while worries about growth and the economy's cracking point may also intensify - the worst of both worlds for central bankers to try to predict or craft a message.
"The economic outlook has turned murkier as the conflict drags on and oil prices remain high and volatile," Subadra Rajappa, head of research at Societe Generale, wrote last week. "While our base case continues to assume a timely resolution and no sustained economic fallout from this conflict...higher inflation and deteriorating labor market conditions make it difficult for the Fed to balance its dual mandate."
(Reporting by Howard Schneider;Editing by Anna Driver and Dan Burns)
