Oil Price Surges, Inflation Rekindled: Will the Fed's Next Move Be a Rate Hike?

Original Title: "An Unthinkable Question Just Weeks Ago: Will the Fed Hike Rates Next?"

Original Author: Dong Jing, Wall Street News

As fuel prices have surged since the outbreak of the Iran conflict, a question that was almost unthinkable just weeks ago has emerged: Will the Fed's next move be a rate hike?

The financial markets are beginning to entertain this possibility. Traders in the derivatives market are pricing in about a 25% probability of a rate hike this year. This shift in expectations highlights the direct impact of geopolitical conflicts on the global energy market and inflation outlook, prompting investors to repricing the Fed's policy path.

While most economists expect the Fed to stay put at the upcoming meeting, the discussion of a rate hike is no longer off the table.

Analysts argue that this development has not only shattered the market's widespread expectation of further Fed rate cuts but has also injected a high level of uncertainty into the future monetary policy trajectory, directly affecting bond yields and stock market risk appetite.

Fed officials will convene for the monetary policy meeting on March 17-18. The market will be closely watching Powell's remarks for any clue about the future rate path.

Inflation Worries Reignite, Calls for Rate Hike Emerge

The surge in oil prices has directly raised inflation expectations, prompting some market participants to call for Fed tightening.

Chief Economist at High Frequency Economics, Carl Weinberg, believes the Fed should hike rates at the upcoming meeting. He predicts that by this summer, oil prices will drive the Fed's favored inflation gauge—the Personal Consumption Expenditures Price Index (PCE)—to a 3.5% annual rate.

"The Fed's job is to minimize the risk of the worst outcome, namely, price acceleration above the target," Weinberg wrote in a report to clients.

He added:

"Even if the Federal Open Market Committee (FOMC) does not hike rates next week—we now refuse to rule out the possibility—officials will certainly discuss the issue, and we expect Mr. Powell to let us know at his press conference."

Despite the calls for a rate hike, most economists do not expect the Fed to take action in the short term. Given the uncertainty brought by the war, nearly all economists expect the Fed to adopt a 'wait-and-see' approach.

Former Dallas Fed President Robert Kaplan Urges Fed to Be Patient, Says, "I have a strange feeling that by the end of March, the situation will look different than it does now."

Former Fed senior official Vincent Reinhart also noted that the majority within the Fed still leans toward easing monetary policy, "but not in a hurry." He believes, "The events in the Middle East have not changed this direction, only giving you more reasons to wait."

Additionally, Deutsche Bank's Chief U.S. Economist Matthew Luzzetti pointed out that a prerequisite for hiking rates is for the labor market to not only bounce back but to strengthen. However, the U.S. labor market has been struggling, adding only an average of 6,000 jobs in the past three months.

Finding Signals of a Policy Shift

While the Fed is likely to keep rates unchanged, economists will be closely watching for any signals about the Fed's next move.

James Egelhof, Chief U.S. Economist at BNP Paribas Securities, said he will be watching whether Fed officials will change their language to indicate whether they plan to cut or raise rates in the coming months.

The Fed's standard script calls for officials to "look through" the oil price shock or treat it as temporary because inflation related to rising oil prices will not persist.

However, Egelhof noted that given the persistently high inflation seen since 2021, Fed officials will be deeply divided on whether to take this approach.

Comerica's Chief Economist Bill Adams agreed that the Fed will signal an openness to both raising and lowering rates. He said:

"If inflation is at the 2% target level, the Fed's concerns about credibility and anchoring inflation expectations would be less than they are now."

Adams pointed out that policymakers may signal that they will use tools to prevent energy price shocks from translating into a rise in trend inflation rates. "This is a conditional willingness to hike, but not a signal of imminent rate hikes."

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