Fed's Diminished Room to Cut
The conflict between Israel and Iran is at risk of widening to critical energy infrastructure. Two main energy facilities are the Shahran oil depot, which has a storage capacity of 260 million liters and a refining capacity of 225,000 barrels per day. The other is the South Pars gas field, which contains 1.26 trillion cubic feet of gas, accounting for approximately 20% of the world's gas reserves.
Thus, energy markets will likely price in a further shock to oil and gas prices, which could impact CPI in the next few months.
Since April, energy has been a drag on CPI by 25 basis points each month. The impact of tariffs from China, as estimated by the Fed’s staff, is eight basis points. The Fed’s rule of thumb, based on its economic model, is that for every sustained $10 rise in energy prices, the CPI could increase by 20 to 40 basis points.
With WTI rising by $7 on Friday and the Israeli attacks on energy facilities potentially adding more upside pressure to oil prices, the Fed may be facing a sustained rise in energy costs.
At the same time, China’s 55% tariffs remain in place for the next six months. CPI and PCE have torque from underneath. The Fed’s recent room to cut rates, i.e., CPI falling while the Fed Funds rate remains the same (also known as the “room”), could be squashed (Figure 1, which includes a projection of CPI in July-September).
Therefore, the Fed could become a third variable added to the mix of uncertainty surrounding tariffs and the Middle East conflict, hindering at least the near-term positive momentum.
Figure 1: Room to cut diminished (real Funds rate, %)
Source: BLS, Federal Reserve
With no spare capacity, the Fed’s dot plot may show wider-than-normal dispersion in dots and projections. Historically, the number of participants reporting higher uncertainty about the trajectory of core PCE has risen since the 2020 pandemic. This measure tracks consumers' uncertainty about inflation in the year ahead, which has also increased (see Figure 2).
While the Fed has lowered and raised rates irrespective of uncertainty, it has influenced the pace of rate cuts, which is the slowest since the mid-1990s (post ’94 super hike cycle). The more uncertain the Fed remains, driven by the confluence of tariffs and energy, the less likely it is that clarity will emerge on its next move.
It may become a repeat of 2015, when heightened speculation around the Fed led to a surge in the dollar, while macroeconomic factors, such as oil prices, caused a deleveraging effect in credit.
Figure 2: FOMC and Consumer uncertainty about inflation (%, number of participants)
Source: New York Federal Reserve, FOMC SEP
To that effect, the upside risk to inflation could cause Fed uncertainty to compound, and this is not yet fully priced in. For example, the market expectations of inflation based on tariffs and energy, as proxied by inflation derivatives and the daily Nowcast of CPI (which is indeed mostly about energy and how tariffs affect food prices), have been falling, even in the last few days(!)
Figure 3: Real-time inflation is still falling despite the oil price jumping (%)
Source: CME, DTCC
With a diminished capacity to cut rates, given the exogenous nature of geopolitics, the Fed must incorporate this into its forecasts in the SEP, which can muddy the bullish outlook the Fed has sustained (by using words like “solid” to describe the economy) since 2023.
Markets not fully reflective of the upside risk to inflation could drive the Fed to a more hawkish tone at the press conference. Recent rhetoric, as captured by the Fed RSI Index (an LLM-based filter of Fed speak), before the blackout, has shifted to the tip of the “hawkish” zone (see the dotted green line and blue line in Figure 4). The Ten Treasury future (“TY”), however, has moved to neutral.
The Fed, in their view, has reason to tilt from being cautious to being hawkish and could do so by moving rate cuts from two to one for 2025, which is a possible, hawkish outcome of Wednesday’s meeting.
Figure 4: Fed RSI Index and Treasury future RSI
Source: CME, FedWatch Advisors