Fed set to keep interest rates steady as Middle East tensions add to uncertainty

Investors to turn attention towards Fed's updated economic forecasts

Federal Reserve chairman Jerome Powell has indicated that the Fed will take a cautious approach towards cutting US interest rates amid tariff uncertainty. AP

The Federal Reserve is poised to keep interest rates unchanged this week, as conflict between Israel and Iran add further uncertainty to the US and global economic outlook.

Fed officials in recent months have acknowledged that risks to both inflation and unemployment are rising as a result of President Donald Trump's tariff agenda.

The three days of tit-for-tat missiles drone strikes on defence and energy infrastructure of Israel and Iran that have pushed oil prices higher also increase the probability that inflation will surge again in the US.

Brent crude, the benchmark for two thirds of the global oil, and West Texas Intermediate, which measures US crude, settled around $74 a barrel after rising more than 13 per cent in the hours following the air strikes on Friday.

“I think, if anything, inflation is going to tick a little bit higher, because oil prices are going to be a little bit higher in the near-term,” said Jay Zagorsky, a professor at the Questrom School of Business at Boston University.

“If I was sitting there in that room … I would say I'm a little concerned about inflation.”

The worsening geopolitical situations in the Middle East also stoke fears that conflict could disrupt trade in the Strait of Hormuz, through which one-fifth of the world's oil passes each day. Significant disruptions could lead to higher energy prices and shipping costs.

“This situation really brings us back to the age old question of risks to oil and gas flows through the Strait of Hormuz,” Colby Connelly, a senior fellow at the Middle East Institute said during a panel discussion on Friday.

“Right now, things in the strait are normal. Vessels are coming and going. There's no sign of any disruption yet, and prices have responded to this risk,” he said.

The tensions add to an already heightened degree of uncertainty facing a US central bank that has opted to remain cautious to offset the potential effects of tariffs on the world's largest economy.

Fed cautious despite tame data

Little has changed in the US economic picture since the Fed last met six weeks ago, and Mr Trump's changing trade policy has offered no clarity either.

Recent data has shown inflation has come in tamer than anticipated, as economists still anticipate a bump in prices because of tariffs. Meanwhile, May's employment data showed that hiring has slowed, which could point towards a resumption in rate cuts.

But inflation still remains above the Fed's 2 per cent goal, and tariff-related issues have not yet been resolved.

“Stay put until something dramatic happens in the economy. Right now, I'm not seeing anything dramatic happening in the US,” Mr Zagorsky said.

Mr Trump has delayed universal tariffs that could lead to a scenario of low growth and high inflation, while also increasing tariffs on steel and aluminium imports to 50 per cent. He announced a trade deal with the UK, while a tariff truce with China eased some of the sky-high levies Washington and Beijing had imposed on each other.

US Fed's Powell says larger-than-expected tariffs will mean higher inflation

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Given this uncertainty, Federal Reserve chairman Jerome Powell and other officials have suggested it could take months before they receive enough clarity to cut rates again.

The Fed has held interest rates at roughly 4.33 per cent since last cutting them in December.

“They're in this environment of substantial uncertainty,” said David Wilcox, senior fellow at the Peterson Institute for International Economics and director of US economic research at Bloomberg Economics.

“It isn't very long ago that we had the Covid-related surge [in inflation] to the worst levels in 40 years. So, they'll put enormous emphasis on ensuring that that doesn't happen,” he said.

Updated projections in focus

With the Fed widely expected to keep rates on hold, attention will shift to the central bank's economic projections. The Fed updates its forecasts for interest rates, inflation, the unemployment rate and gross domestic product every quarter.

In March, Fed officials expected two quarter-point cuts this year, with the unemployment slightly rising to 4.4 per cent and their preferred inflation gauge ticking up to 2.7 per cent.

Minutes released from the March meeting showed officials “judged that inflation was likely to be boosted this year by the effects of higher tariffs”.

Traders currently anticipate the Fed will not resume cutting rates until September, before cutting them by a second quarter-point in December, according to CME Group data.

“My guess is that they'll pare that back to just one rate cut this year. And although they don't have to specify when it comes, my guess is that that will come quite late in the year,” Mr Wilcox said.

The Fed could also adjust its forecast for gross domestic product. Fed officials in March anticipated the economy would grow by 1.7 per cent this year.

The World Bank last week, however, slashed its growth forecast for the US in 2025 to 1.4 per cent

“The rise in trade barriers, heightened uncertainty, and the spike in financial market volatility are set to weigh on private consumption, international trade, and investment,” the World Bank said.