Chances of a Federal Reserve rate cut fade as inflation worsens

WASHINGTON (AP) — The jump in gas prices stemming from the war in Iran has had another impact that may also affect many Americans' finances: Higher interest rates.

Longer-term interest rates have risen quickly since the war began Feb. 28, pushing up the cost of mortgage loans, auto loans, and business borrowing. And with inflation measures likely to rise in the coming months, the prospect of interest rate cuts this year by the Federal Reserve is fading. Wall Street investors instead see the odds rising of an actual rate hike instead.

The fact that a rate hike has become a plausible scenario — even as most economists still see it as unlikely — represents a sharp turnaround from early this year, when the debate was more focused on how many times the Fed would reduce its key rate, rather than whether it would do so at all.

“We think cuts are delayed, not derailed,” Krishna Guha, head of economics at Evercore ISI, an investment bank, wrote Tuesday. “The question is, delayed to September, delayed to December, or delayed more indefinitely” into 2027?

Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said in an interview with The Associated Press Monday that if inflation were to rise while the unemployment rate remained stable, and Americans showed signs of anticipating higher inflation in the future, "then there is an obvious playbook, which is rate increases have to be on the table.” Goolsbee participates in meetings of the Fed's rate-setting committee, but is not one of the 12 voters this year.

Wall Street investors no longer foresee any rate reductions this year, according to futures pricing tracked by CME Fedwatch. And the odds of a rate hike by October have risen to nearly 25%, up from zero just a week ago.

Late Monday, Mary Daly, president of the San Francisco Fed, said in a written statement that the uncertainty created by the Iran war means “there is no single most-likely path” for the Fed's key interest rate, suggesting the Fed could move up, down, or stay unchanged in the months ahead.

The war has created a tricky dilemma for the Fed. Most economists expect that the conflict could worsen inflation by lifting gas prices. But when gas prices rise very high — say $5 a gallon for an extended period — they could force consumers to cut back on spending elsewhere to offset the higher gas costs, slowing the economy and potentially pushing up unemployment.

“On net more inflation means probably higher rates,” said Jonathan Pingle, an economist at UBS. “On the other hand, that energy price shock is going to be a headwind to growth.”

The Fed typically raises rates — or keeps them unchanged — to combat inflation, while they often cut rates to spur the economy and lower unemployment.

When gas prices spike, the standard response for a central bank is to look past the increase in inflation that results because it is often a temporary phenomenon. In that case, the Fed could even cut rates if began to worry that unemployment was worsening.

Yet Federal Reserve Chair Jerome Powell, at a news conference last week, said that assuming the impact would be temporary is more challenging now because inflation has been above its 2% target for five years, souring many Americans on the economy.

For now, many Fed officials are more focused on the threat of higher inflation, suggesting the Fed will keep its key rate unchanged in the coming months. Economists at UBS expect inflation, according to the Fed’s preferred measure, will jump to 3.4% this month and end the year at 3%, above the Fed’s target of 2%.

The unemployment rate “is kind of low and stable,” Goolsbee said. “So that isn’t as far from the target as inflation is right now. And now to pile on a second inflation shock makes me a bit more concerned on the inflation side than on the unemployment side right now.”

When investors expect the Fed to keep its key short-term rate higher for longer, longer-term rates rise. The yield on the 10-year Treasury note has moved up from just below 4% on Feb. 27, the day before the Iran war began, to nearly 4.4% on Wednesday.

Mortgage rates closely track the 10-year, and 30-year fixed rate mortgages are now averaging 6.22%, according to mortgage giant Freddie Mac, up from just below 6% before the war.