Throughout a series of economic shocks that pushed up consumer prices in the past five years, Americans maintained faith that the Federal Reserve would eventually get inflation under control.
They did not waver as inflation soared to a four-decade high in the aftermath of the pandemic, as Russia’s invasion of Ukraine upended energy markets and as President Trump’s tariffs heaped higher costs on consumers. Surveys of consumer sentiment showed that Americans were angry about high prices and pessimistic about the economy. But when it came to inflation, consumers said they still believed it would return to normal within a few years. Investors were similarly hopeful.
The U.S.-Israeli war with Iran is testing that conviction, putting heightened pressure on the central bank as it debates whether to lower interest rates this year.
Progress on getting inflation down to the Fed’s 2 percent target had already stalled before the war in the Middle East began. In fact, officials have missed their goal since 2021. In the past year, tariffs raised the price of imported goods, while solid consumer spending enabled businesses to raise prices for services, such as transportation or personal care.
Spiking energy prices, which have already filtered into higher airfares, fertilizer costs and shipping fees, will worsen the Fed’s inflation problem to some extent. Already, the Organization for Economic Cooperation and Development expects U.S. inflation to rise to 4.2 percent this year, up from 2.6 percent in 2025.
That is on the high side of year-end estimates, but it aligns directionally where most economists see inflation going. According to Goldman Sachs, the Personal Consumption Expenditures price index is forecast to accelerate to 3.1 percent by the end of year, up from 2.8 percent in January. Annual inflation could peak at 4.6 percent this spring before falling back to 3.6 percent by December, the economists warned, if oil prices eclipse their previous 2008 record of $147 per barrel and get stuck around $100 through the final three months of the year.
How bad the inflation problem gets depends on how long the war lasts and how widely price increases spread. The biggest fear for policymakers is a situation in which Americans suddenly turn skeptical about where inflation is headed, setting off a self-fulfilling cycle in which workers, expecting higher prices, demand higher wages to cover those added expenses. Businesses, facing the prospects of higher costs themselves, might then be prompted to raise their own prices to stay afloat.
Once that happens — or as economists say, inflation expectations become “de-anchored” — it becomes much harder for the Fed to bring inflation under control.
In the short run, both investors and consumers expect inflation to jump as the surge in energy prices ripples through the economy. But most measures of inflation expectations indicate little alarm about the trajectory beyond the next 12 months. Measures that are based on financial market activity, which Fed officials watch especially closely, show that medium- and longer-run expectations remain slightly above 2 percent, continuing to convey confidence that the Fed will eventually close back in on its target.
But policymakers know they cannot afford to take this confidence for granted, especially as they contend with mounting concerns about their ability to set rates free of political meddling amid a relentless pressure campaign from the White House. The central bank is also on the cusp of a major transition, with Jerome H. Powell slated to step down as chair in May. His planned successor, Kevin M. Warsh, a former Fed governor, has called for the institution to be overhauled.
“There’s going to be more skittishness from policymakers about just assuming that expectations are going to remain well anchored,” said Maurice Obstfeld, a senior fellow at the Peterson Institute for International Economics and former chief economist at the International Monetary Fund.
“If we’re in a geopolitically much more turbulent era where we keep getting supply shocks, it could affect long-run expectations, and that makes the Fed nervous.”
Lessons From the Past
To some observers, the current situation has uncomfortable echoes of an earlier period of rapidly rising prices, in the 1960s and ’70s.
The 1960s began with an extended period of low inflation and falling unemployment. But inflation began to creep up in the latter part of the decade, as the federal government ran large deficits to fund both the social programs of President Lyndon B. Johnson’s “Great Society” agenda and the Vietnam War. The Fed, wanting to support the economy, initially did little to rein in prices.
Policymakers eventually raised rates, but reversed course when the economy entered a recession at the end of 1969. Inflation cooled but never fully retreated before rising once again. The Fed was slow to respond, partly because President Richard M. Nixon put pressure on Arthur F. Burns, then the chair, to keep rates low heading into the 1972 presidential election.
That meant inflation was already elevated by the time Arab states imposed an oil embargo in 1973, which sent energy prices soaring. Inflation spiked and then eased when the embargo ended roughly five months later. But it did not fully subside before another oil crisis struck. This time, inflation hit a record of nearly 15 percent in 1980 before being brought to a heel by a devastating recession caused by a far more aggressive Fed led by Paul A. Volcker.
There are important differences between those periods and what’s happening now. The 1970s crisis coincided with the end of the gold standard, a globally disruptive event that left central banks without a clear road map for how to set policy. The Nixon administration imposed temporary limits on wages and prices, resulting in a surge in inflation once the policy ended. And today’s Fed has been more consistently focused on keeping inflation under control than in the past.
Still, there are some unnerving parallels: elevated deficit spending, political pressure on the Fed and now an oil shock. The risk, economists say, is a repeat of the earlier pattern, where inflation stays high for long enough that consumers and businesses stop expecting it to return to the Fed’s target.
The central bank managed to avoid this pitfall in the aftermath of the pandemic, when prices began rapidly rising as constrained supply collided with strong demand. Consumers began to expect that inflation would remain high in the short term, but they quickly became confident that it would return to a more normal range within a few years.
“Once it sort of seemed as though the Fed was waking up and actual inflation was falling somewhat, long-term expectations quickly reverted to about 2 percent, even though actual inflation was still well above that,” said Laurence M. Ball, an economist at Johns Hopkins University who studied inflation during the period.
That confidence in the Fed was crucial to the central bank’s success at bringing down inflation without causing a recession — a so-called soft landing that surprised many economists, including Mr. Ball.
“You were bringing inflation back down to the expected level rather than pushing down inflation and expected inflation by bashing the economy on the head,” he said.
Keeping Options Open
At the Fed’s latest policy meeting in March, Mr. Powell made clear that the central bank was highly attuned to the risk of resurgent inflation in light of the war in Iran. He repeatedly stressed that consumer prices were likely to rise, at least temporarily, and affirmed that the Fed was “strongly committed to doing what it takes to keep inflation expectations anchored at 2 percent.”
While Mr. Powell indicated that the central bank would not lower rates unless it saw evidence that inflation was coming back down, he stopped short of providing a specific policy prescription.
For Ricardo Reis, an economist at the London School of Economics, that kind of flexibility is crucial for the Fed to preserve when confronted by an energy shock.
“It would be dangerous to commit to a very strong policy right now,” he said. “Lots of things can happen in the next few months, and some of them involve cutting rates, some involve keeping them steady, and some involve hiking.”
Those who make the case for cuts point to the fact that higher energy prices often crimp demand as consumers are forced to offset higher expenses by pulling back on other purchases. The latest shock also comes at a time when the labor market is noticeably more vulnerable. The unemployment rate is still historically low at around 4.4 percent, but hiring has essentially ground to a halt.
A rate increase appears far-fetched against this backdrop, but the possibility cannot be ruled out entirely. More likely, the Fed will hold rates steady for an extended period as it assesses the economic fallout.
One plausible rationale for raising rates would be if energy-related price pressures bled into measures of “core” inflation, which strip out food and energy items, said Ellen Meade, who was a senior adviser to the Fed’s board of governors until 2021 and is now at Duke University. Further signs that inflation expectations may not be as contained as market measures currently indicate are also likely to prompt a more aggressive stance, she said.
Andrew Schneider, senior U.S. Economist at BNP Paribas, soon expects officials to signal that the next policy move is “ambiguous,” meaning it is equally likely to be a cut as an increase. Without the right response to the ongoing energy shock, Mr. Schneider warned, the Fed could inadvertently undermine its own credibility on inflation.
“If the Fed doesn’t respond to this year after year of overshoot and allows whatever next supply shock to accelerate inflation, then there could be a latent reconsideration of the inflation target, and people in the market could think the Fed is OK with inflation closer to 3 percent,” he said. “That’s a risk right now.”
Colby Smith covers the Federal Reserve and the U.S. economy for The Times.
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