As the economic impact of the US-Israeli war on Iran continues to expand, tensions are escalating among policymakers responsible for controlling inflation.

Federal Reserve officials met on March 17-18, just weeks after the outbreak of war, and Chairman Powell stated that the impact of inflation was likely temporary and primarily confined to the energy sector, opening the door to at least one interest rate cut this year. At the time, Wall Street was also optimistic that if President Trump's nominee, Kevin Warsh, successfully replaced Powell, he would push for rate cuts.



However, the war has lasted far longer than expected and has now entered its tenth week.

At the latest Federal Reserve meeting in late April, officials' anxiety became more apparent. Three officials dissented from the Fed's latest policy statement, objecting to its "dodging bias," which hinted at further interest rate cuts. These officials—Cleveland Fed President Beth Hammark, Dallas Fed President Lori Logan, and Minneapolis Fed President Neal Kashkari—stated in a detailed statement that the Fed had not been candid about the growing risk of further interest rate hikes.

Experts believe they are likely not the only ones with such concerns on the Federal Reserve's 19-member interest rate decision committee, since only 12 members have voting rights each time.

“The resistance to the dovish bias is likely broader than the three people publicly identified,” said Derek Tang, an economist at Monetary Policy Analysis. “The question is, when will inflation expectations collapse? Inflation has been above their 2% target for some time now.”

Supply chains severely disrupted

This is not just a matter of oil prices. The war in Iran has made it difficult for businesses to obtain other key commodities such as fertilizers, helium, and aluminum, thus driving up the prices of these goods. This situation has forced companies across industries to urgently adjust their supply chains and develop strategies to cope with disruptions.

According to the latest business survey by the Institute for Supply Management (ISM), for example, in the April survey released on Tuesday, one utility company said it was “mitigating risk through advance sourcing, supplier diversification, and strategic inventory positioning.”

The New York Federal Reserve's global supply chain stress index surged to 1.82 in April, far exceeding March's 0.68 and reaching its highest level since 2022. This data inevitably evokes memories of the severe shortages of goods and supply chain disruptions that the global economy faced after the 2021 pandemic.

"This is exactly the same situation that the world economy experienced during its recovery from the pandemic, with severe shortages and supply chain disruptions," New York Federal Reserve President John Williams said at an event in New York on Tuesday.

As a member with voting rights this year, Logan echoed this concern in his dissenting statement last week, adding that it could exacerbate inflationary pressures: "The Middle East conflict increases the likelihood of prolonged or recurring supply chain disruptions, which would create further inflationary pressures."

Managing inflation expectations faces challenges

In March, Powell stated that Americans' perception of prices would shape the Federal Reserve's response to the situation in Iran. The Fed closely monitors inflation expectations, especially long-term expectations, as they can be self-fulfilling. If people expect inflation to remain high for the next few years, they will adjust their spending accordingly, which will also be a key indicator of public confidence in the Fed's ability to control prices.

In his speech on Tuesday, Williams said that despite a series of shocks, inflation expectations remain “well anchored.” Key surveys from the University of Michigan, the New York Federal Reserve, and the Conference Board also confirm this.

Kashkari, one of the dissenters, said in a statement last Friday that he was “somewhat comforted” that “market and survey data show that long-term inflation expectations remain well anchored near the 2% target.”

But on Tuesday, market-based long-term inflation expectations rose to a three-year high.

The 10-year inflation-protected yield spread (the difference between the 10-year Treasury yield and the 10-year inflation-protected securities yield) reached 2.5%, the highest level since the beginning of 2023.

Shortly after the outbreak of war in March, Federal Reserve Vice Chairman Philip Jefferson warned: "The longer inflation stays above 2%, the more likely it is to become entrenched in expectations, making it more difficult to achieve the (Federal Reserve's) goals."

Overall, the ongoing war with Iran not only tests the Federal Reserve's monetary policy flexibility, but also highlights how geopolitical conflicts can be rapidly transmitted to the global economy through energy and commodity channels.

Market participants and policymakers are closely watching data in the coming weeks to determine whether inflationary pressures will force the Federal Reserve to shift from an "accommodative" stance to a more cautious or even tightening one. Such a shift, if it occurs, would have profound implications for global financial markets, including rising borrowing costs, slower business investment, and increased financial strain on ordinary households.