(Yahoo! Finance) - Just over a week ago, deliberations inside the Federal Reserve looked a lot different than they do now.
The war in Iran, which has pushed up oil prices to around $100 a barrel, is scrambling the path the Federal Open Market Committee may have seen for interest rates this year.
Oil's sudden increase has implications for inflation and economic growth — pushing inflation up, growth down, or both — depending on how long the conflict persists.
“I think it's more of an impact on growth when we look a year out,” Wilmington Trust chief economist Luke Tilley told Yahoo Finance on Monday. “It will hit CPI and PCE headline inflation right away, but I don't think there's a lot of pass-through to core inflation, and there's more of a concern for economic growth than for inflation.”
Historical research shows that as long as the oil price shock comes from the supply side, it doesn't lead to high “core” inflation — the price measure that excludes energy and food prices — even though it will show up in headline numbers.
Instead, Tilley said, research shows spikes in oil hurt growth.
The biggest question, and the one that will have the most implications, is how long the war lasts. Tilley estimates that if oil stays at $100 a barrel for three months, it will be really close to tipping the economy into recession.
“The more you move from a one-week spike to a three-month spike in higher numbers, the bigger of a drag it is on the economy,” Tilley said.
He likened the oil price spike to a tax increase because, as the cost of gas goes up, people can't avoid it. That spells less income to spend on other things at a time when Tilley called the job market “precarious.”
A bad jobs report at a bad time
At the same time as the oil shock, signs of stabilization in the labor market are now in question following the February jobs report, which saw payrolls plunge by 92,000.
A little over a week ago, Fed officials were looking at an economy poised to benefit from tax refunds, low gas prices, an improving job market, and fading tariff effects in the second half of the year. Having cut interest rates three times last fall to steady the labor market, many members of the Fed were content to hold rates steady while eventually looking to lower them.
Tilley said he thinks the discussion within the FOMC will shift from whether the federal funds rate is at a neutral level, designed to neither spur nor slow economic growth, to whether monetary policy should become more accommodative.
If it's the latter, that could make a case for lower rates.
But central bankers who still have concerns about inflation are likely to dig in deeper due to the oil price shock. At the last policy meeting, several officials felt further rate cuts would make sense if inflation were to decline in line with their expectations. But others indicated that they would have supported a two-sided description of the Fed's future interest rate decisions reflecting the possibility of raising rates if inflation remains above the central bank's 2% target.
Esther George, former president of the Kansas City Federal Reserve, said in an interview she’d “love to see them quit focusing on when they can resume rate cuts because I think the path of inflation and other things was already uncertain.”
“Now is not the time to try to tease out where they think the neutral rate is because you've got a lot going on in this economy that could turn in a lot of different directions,” George said.
For those members of the Fed already concerned about inflation, George said the oil price shock pushes out the discussion of rate cuts until next year.
“Even if you get this resolved in a month or two, you're going to have the lingering effects of these higher prices going into the fall,” she said.
With consumer spending accounting for 70% of economic growth, and consumers already under pressure from prices that have risen over the past five years, it won’t take much to cause a pullback, George said.
Add in tariffs, and a job market George described as “performing in odd ways,” and it wouldn't take much to tip the economy toward slower growth.
How quickly have the dynamics flipped?
Looking at the change in forecast Fed interest rate moves since the end of February, traders have priced out one full cut.
“All the fundamental drivers are going to be changing pretty quickly,” Tilley said.
By Jennifer Schonberger - Senior Reporter
