US Fed on 'knife edge' as oil prices heap pressure on inflation risk

Traders predict the US Federal Reserve will raise interest rates this week to combat inflation resulting from the Iran war. A staggering 90% of traders forecast a 25 basis point increase on Wednesday, marking a shift from the nine-month pause that preceded it. This decision is expected to mirror that of the UAE Central Bank. Derek Tang, an economist at MPA Macro, noted that people are finally acknowledging the risk that the Iran war will continue, leaving no respite for energy prices.

Oil prices surged by nearly 8% last week following the intensifying tension in the Gulf, including the Houthis seizing the Red Sea port city of Mokha. Brent crude closed at $104.50 per barrel on Friday, following Saudi Arabia's announcement that it had shut down the East-West Pipeline due to multiple attacks. This pipeline is one of the kingdom's most lucrative crude export routes, capable of pumping seven million barrels daily, according to official data.

The closure of the pipeline could signify a critical juncture in the ongoing conflict. Tanker traffic in the Strait of Hormuz, where approximately 20% of global energy supplies passed before the war began, remains far below pre-conflict levels, as indicated by the IMF's PortWatch tool. Price pressures have subsided recently after surging to 4.2% in May due to the energy-driven inflation surge from the Iran war.

However, Fed Chair Kevin Warsh now faces the challenge of determining if inflation is approaching the central bank's 2% target. Michael Pearce, chief US economist at Oxford Economics, likened the current situation to the Fed standing on a "knife edge." He posed the question of whether the inflation's decline is occurring at a pace he finds satisfactory or if a rate hike would better balance the risks to the economy.

Recent US government data indicated that headline inflation remained steady at a 3.4% annualized rate in August, in line with expectations. Core inflation, excluding volatile food and energy indexes, rose by 2.4% year-on-year, also meeting expectations. The report revealed that petrol prices have increased by 27.4% compared to the same period last year, and rose by 3.9% on a monthly basis in August.

While the report may not be "hot," it was deemed sufficient to tip the scales towards a quarter-point rate increase. US drivers are now paying an average of $4.29 per gallon, up from last year's average of $3.19. US diesel prices have soared above $6 per gallon, up from $3.70 at this time last year, making it more expensive for freight networks to deliver everyday goods.

These increased costs could soon be passed on to consumers. The latest inflation reading also places Warsh in a tight spot. He warned during the Jackson Hole symposium last month that recent better-than-expected inflation readings do not provide confidence to support a hike. "We are deeply skeptical of tighter monetary policy as an antidote to energy-induced inflation," Wells Fargo economists wrote in a note.

"Right now, it's the Fed's world, and we're just living in it." Bond market volatility adds to the Fed policymakers' predicament this week. US long-term yields have recently reached a near two-decade high due to inflation concerns and rising government debt. This could make it more expensive for Gulf countries that may need to borrow to compensate for lost revenue from the Iran war.

The Treasury Department announced the US would buy back $6 billion worth of government debt to stabilize the US bond market. However, the yield on the 10-year Treasury hit its highest level since 2023. "All of these challenges essentially mean that policymakers are going to need to be both nimble and credible," said IMF communications director Julie Kozack during a briefing.

Bond markets are closely monitoring Warsh's performance, especially following his perceived unconvincing press conference in July, where he suggested bond yields could hinder his ability to hike interest rates.