Former Fed Official: Faced with Iran's Energy Shock, the Fed's Only Option is to "Wait and See"

The Federal Reserve is facing a new test compounded by multiple pressures. Beyond trade disputes, artificial intelligence uncertainties, and threats to its independence, an energy supply shock stemming from the Iran conflict has become the latest dilemma for monetary policymakers.

Former President of the Federal Reserve Bank of New York and Bloomberg columnist Bill Dudley believes that the Fed will adopt a wait-and-see approach until the scale and duration of the shock become clearer.

Dudley wrote in an article published Thursday that oil prices have significantly surpassed $100 per barrel, and year-over-year inflation, measured by the Personal Consumption Expenditures price index, could approach 4% in the coming months. Meanwhile, strong non-farm payroll growth in March indicates that the economy remains resilient, partially offsetting the short-term drag from rising energy prices.

Against this backdrop, the Fed's policy options are constrained by multiple factors. Any interest rate cut could invite skepticism about its policy motives, especially at a time when the Trump administration continues to pressure its independence and Trump nominee Kevin Warsh is poised to take over as chairman.

Scale and Duration of Supply Shock Remain Highly Uncertain

In Dudley's view, the full picture of this energy shock has yet to emerge.

Currently, oil and gas shortages are primarily concentrated in maritime transport – with vessels that should have been heading to Europe and Asia now stranded in the Persian Gulf. If the blockade of the Strait of Hormuz persists, shortages will gradually spread to land terminals in import-dependent countries. Even if the strait reopens, it will take weeks for affected regions to replenish depleted inventories.

The current fragile ceasefire makes the outlook even more unpredictable. The ultimate scale and duration of the shock will directly determine whether the Fed needs to act and in which direction.

Dual Pressures of Inflation and Growth Create Policy Dilemma

The impact of rising energy prices on the economy is twofold.

On one hand, higher energy costs will depress real incomes and curb consumption, with a particularly noticeable impact on low-income households lacking financial buffers. On the other hand, rising energy prices will directly push up overall price levels.

With inflation having exceeded the Fed's 2% target for five consecutive years, this shock makes policy formulation more challenging. Although the Fed has historically tended to "look through" temporary price shocks, this approach faces greater challenges in the current environment.

Currently, long-term inflation expectations remain relatively stable – the five-to-ten-year forward inflation expectations implied by Treasury Inflation-Protected Securities (TIPS) have stayed slightly above 2% since the conflict began, and household survey data also remains stable. However, analysts suggest it may be too early to determine if expectations have changed substantially.

Economic Resilience Offers Cushion, but Recession Risks Cannot Be Ignored

The US economy currently possesses some support.

Strong March employment data, coupled with tax reductions on overtime pay, tips, and social security contributions from last year's "Big Beautiful Bill" leading to higher tax refunds, are expected to offset the negative impact of rising energy prices in the near term. Some households have even enjoyed overtime tax relief beyond the legislative intent, with actual boost effects potentially exceeding expectations.

However, long-term risks should not be underestimated. Research by economist Jim Hamilton of the University of California, San Diego, indicates that energy shocks have historically been significant triggers for economic recessions. The current labor market has calmed, with both hiring and layoff activities at low levels.

If this energy shock leads to sustained pressure on consumer spending, and if it is sufficiently large and prolonged, it is not impossible for the economy to eventually fall into recession – although AI investment, fiscal stimulus, and relatively loose financial conditions remain important counterbalancing forces.

Increased Pressure on Fed Independence Complicates Policy Operations

In terms of monetary policy operations, the Fed faces not only economic dilemmas but also additional political constraints. The Trump administration's continuous attacks on the Fed's independence make any decision to cut interest rates susceptible to being interpreted as a capitulation to political pressure, thereby undermining market confidence in the Fed's commitment to fighting inflation.

With the expectation of Kevin Warsh taking over as chairman, market assessments of the Fed's future policy direction become more complex. Dudley believes the Fed must be exceptionally cautious to ensure its actions do not disrupt inflation expectations. For now, until the severity and duration of the shock, and its impact on inflation expectations and the job market, become clear, a wait-and-see approach is the most prudent choice. It will not be too late to act if the risks clearly tilt towards one side of the dual mandate – price stability or full employment.

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