Oil price drop and reopened Strait of Hormuz may change Fed's options on future rate cuts

The Federal Reserve's policymakers face a complex outlook as they prepare for their meeting on April 28-29. The reopening of Iran's Strait of Hormuz has caused oil prices to fall below $90 per barrel for the first?time in over five weeks. U.S. Central Bank officials are now assessing the damage that the seven-week conflict had done to price trends and whether the hostilities have ended for good.

Iran announced on Friday that it will reopen the Strait of Hormuz, which is responsible for about a fifth the world's supply of oil, to shipping during the current ceasefire between the U.S. and Israel. The global oil price, which had been hovering around $95 per barrel, plunged to $89 and traders of contracts linked to Fed interest rate changed their views from the central banks remaining inactive until 2027 to the Fed resuming rate cuts as early as this year.

Neil Dutta is the head of Renaissance Macro Research's economic research. He said that the Fed could now set aside the concerns about stagflationary fears of increased inflation and a slowing of growth due to the oil shock, and pursue rate reductions on the basis of a renewed decline in inflation.

In a note, he said that the consumer's purchasing power would improve and they would spend less money on basic items like gasoline. According to AAA, the average gasoline price has already dropped from its recent high of $4.15 per gallon to $4.07 per gallon on Friday. Mary Daly, the San Francisco Fed president, said in a recent interview that the Fed could be influenced by the outcome of the conflict and how oil prices might respond if hostilities eased.

Daly stated in an interview that "as long as the conflict is resolved quickly, it will take longer but it won't stop the progress". It just takes a little longer for everything to be resolved." The Fed will likely keep its overnight benchmark interest rate at 3.50% to 3.75% when it meets later this month. Inflation has not improved in recent months, and there are new risks surrounding its direction.

The Fed's language was becoming more hawkish, as the concern grew that the Middle East war, which lasted seven weeks, was not just a disruption they could "look past" but rather was causing broader price pressures. In remarks made this week, New York Fed President John Williams began to sketch out the conditions that had already begun to play themselves out in the form of increased fuel costs, larger supply chain problems, and higher airfares and groceries.

Williams, a vice-chair and permanent voter in the Federal Open Market Committee of the central banks, said "even based upon what we have seen so far, inflation will be above 3% within the next few month." This is a major miss by the Fed, and a move in the wrong direction based upon the Personal Consumption Expenditures Prices Index, which the central bank uses as metric to set its inflation targets.

In February, which is the last month where data are currently available, the headline PCE, excluding energy and food, was 2.8% year-over-year. The core measure was 3%. Analysts expect that the core PCE will have increased to 3.2% by March. This data will be released on April 30th, a day following the Fed's second meeting.

Consumers may be eligible for a possible relief

The Fed's view on the economy, inflation, and interest rates will be affected by the latest events if the apparent progress in resolving the conflict continues. This could drive oil prices lower. The President Donald Trump labeled this week as "fake", the inflation that occurred as a consequence of his decision launch air strikes against Iran. A sharp rise in the Consumer Price Index headline in March was the fastest since 2022, when former President Joe Biden led the surge in inflation during the pandemic era. Economists do not include energy or food prices in the "core" concept that captures inflation trends better. Fed officials and comments from the Fed’s “Beige Book” survey of economic reports around the country began to focus on higher core prices that policymakers saw as possibly developing due to the energy shock. As firms reset their charges to account for increased input costs and fuel and energy contract adjust to?account? for market pricing, they began to see this increase in core inflation.

If the relief in oil price is sustained, it will be felt by consumers who can now spend more on other goods and services. This could boost economic growth.

Stephen Miran, Fed Governor, said this week that every dollar consumers spend on higher energy costs is $1 less they can spend on other items. He was advocating for a rate reduction at the Fed meeting next week. "I don’t think this is the kind of thing that will drive us into a recession, but I do believe it's going to be a drag on the growth. And in a labor markets that were very slowly drifting away form full employment, that's something that could make you worried." Reporting by Howard Schneider, Ann Saphir and Chizu Nomiyama. Editing by Paul Simao and Chizu Simao.

(source: Reuters)