Fed 'utterly paralyzed' as Iran conflict stokes stagflation fears

By Greg Robb

Weak jobs report, higher gas prices move central bank to the sidelines

Federal Reserve Chair Jerome Powell and his colleagues will meet on March 17-18 to set interest rates.

At the beginning of the year, it looked as if the Federal Reserve had managed to put the U.S. economy back on a track toward a soft landing, with the labor market stabilizing and high inflation slowly cooling.

But the events of the past several days have thrown all of that into question.

Inflation, already well above the Fed's 2% annual target, is going to get a boost as gasoline prices spike as a result of the conflict in the Middle East.

Meanwhile, the central bank's hope that declines in the labor market had slowed took a hit Friday, with a surprising plunge in job growth recorded in February.

"The conflict in the Middle East combined with the latest jobs report makes the Fed's job more difficult. It also starts to smell a bit more like stagflation - meaning we could have higher inflation but also weaker growth," said Beth Ann Bovino, chief U.S. economist at U.S. Bank, in an interview with MarketWatch.

Stagflation was coined in the 1970s, when surging inflation and a poor economy saw interest rates at close to 20% and unemployment at around 10%. That's far above current levels, with the unemployment rate now at 4.4% and the Fed's benchmark interest rate at a range of 3.5% to 3.75%.

Still, even hints of stagflation put the Fed in a bind, as any more rate cuts aimed at helping the labor market could push up inflation.

"Stagflation is always the worst-case scenario for the central bank, because there's not an obvious monetary-policy answer," Chicago Fed President Austan Goolsbee said in an interview with Bloomberg on Friday.

What will the Fed do? Nothing, at least in the short term.

"I think sitting on the sidelines is all they can do," said Richard Moody, chief economist at Regions Financial, in an interview with MarketWatch.

Fed officials will gather to discuss interest-rate policy on March 17-18.

"It's hard to imagine them cutting into this environment given the considerable spikes in gasoline we've seen," Moody said. Prices at the pump hit their highest level in two years following the start of the Iran war.

Many Fed officials hesitant to cut

Moody said the minutes of the Fed's January meeting show there is "a lot of resistance to further rate cuts" among Fed officials.

This was evident Friday, as Fed officials including Boston Fed President Susan Collins and Cleveland Fed President Beth Hammack said the weak jobs data hadn't altered their view that interest rates could be on hold for quite some time.

Stephen Stanley, chief economist at Santander Corporate and Investment Banking, said a March rate cut had already been ruled out by the Fed after its last meeting in January. The conflict in the Middle East "has pushed the Fed even further to the sidelines for now," he said.

"I think the FOMC is going to sound utterly paralyzed on March 18," said Derek Holt, head of capital-markets economics at Scotiabank.

At the meeting, the Fed officials who are more worried about inflation than their colleagues will be on edge, while other officials will focus more on the deteriorating jobs market. The two camps will cancel each other out, Holt said, "until greater clarity on the extent and duration of the energy shock and the deterioration of the job market is realized."

Still, Thomas Simons, chief U.S. economist at Jefferies, said he believes the door is slightly open for a rate cut in April.

On the other hand, if the war is extended, the Fed may have to consider raising rates if the risk premium in oil (CL00) (CL.1) remains high and starts to get embedded into inflation expectations, according to U.S. Bank's Bovino.

-Greg Robb

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03-07-26 0700ET