Fed should ditch rate-cut lean because of oil shock, policymakers say

By Howard Schneider and Michael S. Derby

WASHINGTON, May 1 (Reuters) – Federal Reserve officials who dissented against this week’s policy statement said on Friday the developing oil price shock from the war in Iran means the U.S. central bank should be clear it can no longer lean towards interest rate cuts, with a rise in borrowing costs possible in the future.

In its most divided vote since 1992, the Fed this week kept its benchmark overnight interest rate steady in the 3.50%-3.75% range but retained language indicating its likely next move would be a cut, consistent with a process begun about 18 months ago of lowering the high levels of borrowing costs used to battle inflation towards a more “neutral” stance.

But inflation remains well above the Fed’s 2% target and has been rising, with risks about the outcome of the war so acute that policymakers have become less certain rates can fall from where they are. Some of them are concerned they may in fact need to rise.

“Inflation pressures continue to be broad-based, and rising oil prices present an additional source of inflationary pressure,” said Cleveland Fed President Beth Hammack, who like two other central bank colleagues supported holding rates steady but dissented because of the “easing bias” in the rate-setting Federal Open Market Committee’s policy statement.

“I see this easing bias as no longer appropriate given the outlook,” she said in a statement.

Dallas Fed President Lorie Logan echoed that sentiment.

Given the uncertain outlook for the economy, “it could plausibly be appropriate for the FOMC’s next rate change to be either an increase or a cut,” Logan said in a separate statement, adding that the Fed “should not give forward guidance implying a bias toward rate cuts at this time.”

Minneapolis Fed President Neel Kashkari said he felt a prolonged closure of the Strait of Hormuz and any further damage to Middle East energy infrastructure could produce a price shock large enough that the Fed would need “potentially a series” of rate hikes to keep inflation expectations in check.

“With an extended closure of the Strait of Hormuz and potentially further damage to energy and commodity infrastructure in the Middle East … the price shock wave could be much larger than is currently expected,” Kashkari said in a separate statement released as the lid on Fed policy communications lifted after the end of this week’s meeting.

“We would likely have to follow through with a strong policy response … Federal funds rate increases, potentially a series of them, could be warranted even at the risk of further weakness to the labor market.”

The policy statement, approved on an 8-4 vote this week, repeated existing language to indicate the easing bias three voting Fed officials felt is no longer appropriate, with other non-voting members of the central bank’s policy committee likely in agreement. The fourth dissent was in favor of a rate cut.

MARKET-BASED MEASURES OF FUTURE INFLATION EXPECTATIONS RISE

Closure of the Strait of Hormuz, a vital shipping channel for the world’s energy supply, and threats to infrastructure have pushed the global price of oil well above $100 a barrel for several weeks, touching $126 just this week versus $70 at the start of the conflict two months ago.

The average price of U.S. gasoline jumped by nearly 10 cents overnight to about $4.39 a gallon, according to motorist advocacy group AAA, versus around $3 as of late February.

Omair Sharif, president of Inflation Insights, said that while it was still “early days,” the Fed ahead of its next meeting in June could see a consumer price reading for May that tops 4%, echoing the surge of inflation that followed the COVID-19 pandemic and the 2022 Russian invasion of Ukraine.

Kevin Warsh, who is expected to win Senate confirmation in the coming weeks to replace Fed Chair Jerome Powell as the head of the central bank, could “face not just surging energy inflation that threatens to spill into the broader economy but also likely rising inflation expectations figures,” Sharif wrote on Friday. “That is a tough environment from which to argue for rate cuts,” that President Donald Trump has said he expects Warsh to deliver.

Though Fed officials say they regard inflation expectations as currently stable, a key consideration in managing the future inflation outlook, surveys of households have shown their expectations for near-term inflation have risen sharply since the war began, while their outlooks for the rate of price increases over a longer horizon have edged up more modestly.

Market-based measures, meanwhile, have begun moving up.

The inflation rate implied by the yields on 10-year Treasury Inflation-Protected Securities is the highest since 2023 and has climbed about 25 basis points since the war began, and the rate on 5-year TIPS has also climbed by about the same margin. What’s known as the 5-year, 5-year forward rate, a measure of expected inflation five years from now for the following five years after that point, is up about 20 basis points since late February and is near its highest level since the start of the year.

Powell, in his post-meeting press conference on Wednesday, said the inflation dynamics around the war were fluid enough that the “center” of thinking among Fed officials was moving towards removing the easing bias from the statement in favor of more neutral language opening the door to a rate hike, a change he said could come, depending on events, as soon as the June 16-17 policy meeting.

In his statement on Friday, Kashkari pointed to another potential issue with the “easing” language. According to his analysis, even under a “benign scenario,” where the Strait of Hormuz opens relatively soon to allow the flow of oil and other global commodities to resume, underlying inflation in the U.S. would remain at 3% for the year – well above the central bank’s target and high enough in his view to leave the policy rate unchanged for what would likely be an extended period of time.

(Reporting by Howard Schneider and Michael S. Derby; Editing by Chizu Nomiyama and Paul Simao)