Iran War Escalation Intensifies Fed Internal Divisions; High Oil Prices May Trigger U.S. Economic Recession

Federal Reserve officials are holding a two-day policy meeting this week, and the oil price shock triggered by the Iran conflict could further deepen disagreements within the Fed over the path of interest rates.

Former Kansas Fed President Esther George said in an interview, “I hope they stop obsessing over when to restart rate cuts because, in my view, inflation trends and other factors are inherently uncertain.”

“Now is not the time to judge the neutral interest rate level, as there are too many factors in the economy that could develop in different directions.”

A few weeks ago, the core debate within the Fed was how far interest rates were from the neutral level—the benchmark rate that neither stimulates nor restrains economic growth.

At that time, Fed officials saw the economy supported by factors such as tax refunds, low oil prices, a stabilizing labor market, and diminishing effects of tariffs. The Fed had cut rates three times last fall to stabilize employment, and many members preferred to hold steady and observe future developments. Fed Chair Jerome Powell had stated that current rates were within the estimated neutral range.

Now, the situation is changing, and much will depend on how long the Iran conflict lasts and how long high oil prices persist. Trump’s recent statements have been contradictory: on one hand, saying the Iran conflict will “end very soon,” and on the other, indicating U.S. military actions will continue. He also said preventing Iran from obtaining nuclear weapons is more important than domestic oil prices.

George said, “Even if the conflict is resolved in a month or two, the lagged effects of high oil prices will persist into this fall.”

She added that consumer spending accounts for 70% of U.S. economic growth, and rising prices over the past five years have already strained consumers, meaning even small shocks could lead to a pullback in spending.

Persistent Inflation

Amid the oil price shock, U.S. inflation has been above the Fed’s 2% target for five consecutive years, with tariffs further pushing up prices over the past year. The Fed’s preferred inflation indicator—the personal consumption expenditures (PCE) price index excluding volatile food and energy—was still high at 3.1% earlier this year, mainly driven by rising service sector prices. In February, before the Iran conflict erupted, the Consumer Price Index (CPI) rose 2.5% year-over-year.

However, Wilmington Trust Chief Economist Luke Tilley said he believes the Fed’s internal discussions will shift toward whether monetary policy should become more accommodative—that is, lowering rates below the neutral level.

“Research shows that sustained high oil prices pose a greater risk to economic growth than to inflation,” Tilley said. “The Fed will take a cautious stance, balancing upside inflation risks with downside growth risks.”

Tilley estimates that if oil prices stay at $100 per barrel for three months, the U.S. economy could approach recession.

“From a short-term spike to sustained high levels over three months, the drag on the economy will grow.”

However, Jim Baird, former St. Louis Fed President and current Dean of Purdue University’s Krannert School of Management, is not too worried about the impact of oil prices because the U.S. has shifted from a net importer to a net exporter of oil.

“U.S. oil production is sufficient for self-sufficiency. From this perspective, the impact of oil price shocks on the U.S. economy should not be too significant,” Baird said in an interview.

Regarding inflation, Baird expects overall inflation to rise, but core inflation excluding food and energy will not increase significantly, and inflation expectations remain stable.

“Fed members will feel reassured and believe inflation expectations will not change much,” he said. “Although this is a major global issue, based on current information, I don’t think the impact on the U.S. will be that severe.”

George expects the surge in oil prices will draw the Fed’s attention to inflation, but also that some will see it as a temporary supply shock that the Fed can choose to ignore for now.

Tilley noted that history shows supply-side oil shocks usually do not push up core inflation and tend to slow economic growth instead.

Some policymakers may still favor rate cuts, while others wary of inflation might delay further cuts until next year.

Likely Hold on Rates

At the last policy meeting, although some officials believed that if inflation fell as expected, further rate cuts would be reasonable, others advocated for a dual approach—indicating that if inflation remains above 2%, rate hikes could also be appropriate.

Market pricing currently suggests the Fed will not cut rates until December, with a high probability of maintaining the current 3.5%–3.75% range this week.

At this meeting, officials will release the quarterly “dot plot,” showing each member’s expectations for rate changes over the next two years. However, Tilley from Wilmington Trust said that given high oil prices, tariffs, and employment market uncertainties, the dot plot’s reference value is diminishing.

“The committee is quite divided, and the dot plot will likely be very dispersed,” Tilley said. “It’s hard to make predictions now, as all the main drivers are changing rapidly, so expectations will be highly divergent.”

Tilley believes the U.S. labor market is not stabilizing but stagnating. He expects the Fed to cut rates three times this year, citing a weak employment market and overestimated GDP data.

George also sees the labor market as “on thin ice,” and the Fed can only wait and see.

“Although the unemployment rate is low, the Fed currently has no confidence in either of its dual mandates,” she said.