Iran War Tests Fed's Patience on Interest Rates

The ongoing war in Iran is putting pressure on oil prices and testing how long the Federal Reserve can look past an energy shock that has been ongoing for months without adjusting interest rates.

Central banks typically look through energy shocks, assuming prices will eventually normalize. However, it's becoming increasingly difficult for the Fed to do so as oil prices remain high, surpassing $90 a barrel after renewed fighting this week.

The challenge for the Fed goes beyond the level of energy prices and whether they are becoming a persistent source of inflation. Inflation has retreated significantly from pandemic highs but remains stubbornly above the 2% target. Core measures have also been firmer than expected in the first half of the year.

Fed officials, including Chairman Kevin Warsh, are grappling with how to respond. Warsh said underlying trends in inflation had not meaningfully improved and that the central bank may need to raise rates to address it. Fed governor Michael Barr stated that rates may need to go up unless new data shows price pressures easing.

The odds of a quarter-point rate hike increased after Warsh's speech last week, with investors pricing in a 66% chance of a hike at the next meeting later this month. Pressure is also mounting on financial markets, with 10-year Treasury yields climbing to highs not seen since 2007.