The economic outlook is shrouded in uncertainty, and the policy maneuvering space for Waller at the Federal Reserve may be significantly narrowed

The situation in the Middle East continues to escalate, fundamentally reshaping the Federal Reserve's policy path. The surge in oil prices, rising inflation expectations, and a softening labor market have significantly dampened market expectations for the new Federal Reserve Chair nominee, Walsh, to quickly push for interest rate cuts upon taking office.

Brent crude oil prices have returned to above $100 per barrel, and gasoline prices have jumped to about $3.60 per gallon, over 20% higher than before the outbreak of hostilities. Meanwhile, the 30-year mortgage rate rose to 6.11% this week, and U.S. Treasury yields have increased across the board. Market expectations for a rate cut at Walsh's first meeting have been pushed back from June, with some forecasts delayed until December, while CME Group's FedWatch indicates that the next rate cut may not occur until the end of 2027.

Walsh is yet to be confirmed by the Senate and is expected to take over from current Chair Powell in May. However, the inflationary pressures brought on by the war, Trump's continued pressure for immediate and significant rate cuts, and the Federal Reserve's own credibility concerns are placing this prospective chair in a web of contradictions, with the policy maneuvering space rapidly narrowing.

Oil Price Shock Fully Penetrates the Economy

The Strait of Hormuz remains obstructed, compounded by the shutdown of regional oil and gas infrastructure, driving oil prices to rebound strongly even after major developed countries coordinated the release of strategic reserves. Rising energy prices are transmitting along the supply chain downstream—from gasoline and diesel to airline ticket prices, and even affecting food prices due to potential increases in fertilizer costs.

Vincent Reinhart, Chief Economist at BNY Investments, pointed out that the Federal Reserve's response will "depend on the scale, scope, and duration of the oil price shock." He emphasized that the transmission pathways of rising energy costs in the economy are complex, as they can both push up certain prices and lead consumers to cut back or shift spending, altering expectations for economic growth and employment.

Reinhart specifically noted that the experience of inflation soaring to the highest levels since the 1980s over the past five years may have made the public's inflation expectations more sensitive. "If the expectation anchor is not strong enough, it will manifest more as rising inflation rather than impaired growth." He believes the Federal Reserve still leans towards cutting rates, but "current uncertainty is extremely high, and the appropriate policy is to hold steady and wait for developments."

Federal Reserve Meeting Next Week: Holding Steady, Focus on Wording

Federal Reserve officials are expected to maintain the policy interest rate at 3.5% to 3.75% at next week's meeting. The focus will shift to the wording of the new statement, Powell's remarks at the press conference, and the latest economic forecasts that will incorporate assessments of the war's impact for the first time.

The interpretative challenges facing officials extend beyond the situation in the Middle East. The direction of tariff policies, adjustments to immigration policies, and the recent impacts of regulatory and tax changes on businesses and households all constitute significant sources of uncertainty. Meanwhile, government statistical data is lagging, and behavioral changes will take time to manifest in high-frequency data.

Michael Gunther, Senior Vice President at Consumer Edge, stated that since the outbreak of the conflict, credit and debit card spending data suggest that consumers may have begun to adjust their behavior—online shopping orders have increased, and the average spending per visit at some stores has also risen, possibly to reduce the frequency of outings But he emphasized, "Since the conflict began on February 28, we have not seen a significant decline in consumption."

Inflation data remains high, interest rate cut window may be closed for the year

The Federal Reserve's preferred inflation measure—the core Personal Consumption Expenditures (PCE) price index—rose 3.1% year-on-year in January, the highest level since March 2024. Notably, this data does not yet reflect the recent surge in energy prices following the outbreak of conflict, and subsequent inflationary pressures may be more pronounced.

Gregory Daco, chief economist at EY Parthenon, stated that he currently expects the Federal Reserve to cut interest rates no earlier than December, and noted that "it is entirely possible that the Federal Reserve will not cut rates at all this year." This position will create direct friction with incoming Chairwoman Waller and Trump's ongoing calls for immediate and significant rate cuts.

February employment data is also concerning—non-farm payrolls unexpectedly decreased by 92,000, highlighting worries about a softening labor market. Luke Tilley, chief economist at Wilmington Trust, pointed out that current job growth is highly concentrated in the healthcare sector, stating, "Historically, there has never been a situation where so many jobs were lost outside of healthcare without entering a recession." He expects the Federal Reserve to maintain a hawkish tone at next week's meeting but will also acknowledge the downside risks to growth and ultimately initiate a rate-cutting cycle within this year