Inflation’s Back. Jobs Aren’t. The Fed’s Task Just Got Harder

The Iran war puts the Federal Reserve (Fed) in an unenviable position.

Higher energy prices pushed the annual Consumer Price Index inflation from 2.4% in February to 3.3% in March, with another increase expected in April. At the same time, the labor market remains soft, with monthly job gains over the past half year averaging only 15,000. With risks to both sides of its mandate of low inflation and maximum employment, what should the Fed do?

The usual playbook suggests looking through the temporary shocks to inflation. If the disruptions to energy markets ease soon, they would fall right into this category. However, the context makes things a little more complicated. Inflation has remained above the Fed’s 2% target since March 2021. The Fed is also wary of repeating its mistake of underestimating the inflation shock and delaying the necessary policy adjustments the way it did in 2022, which allowed inflation to surge to a 40-year high. That misstep challenged the Fed’s inflation-fighting credibility and will likely strengthen its resolve not to let inflation out of control this time.

But is an inflation surge like the last one even possible? It seems unlikely. First, it appears that the increase in energy prices and disruptions to supply chains might really prove temporary if tensions in the Persian Gulf ease. Second, the fiscal and monetary policy are in a very different place now. The Fed’s federal-funds interest rate sits at 3.50-3.75% and does not add fuel to the inflation fire, least of all compared to zero interest rates and aggressive quantitative easing back in 2021. Similarly, although fiscal policy is mildly stimulative due to different provisions of the One Big Beautiful Bill Act, it pales in comparison to the massive fiscal thrust of post-COVID-19 stimulus packages.

Finally, the economy’s business-cycle position is different, meaning that lasting inflation increases are less likely. The relatively soft labor market and lack of consumers’ excess savings lowers the chance of higher energy spilling over to wages or prices of non-energy consumer goods. If anything, slow employment growth and the persistent “no-hire, no-fire” environment leave the labor market vulnerable and call for an easier, not tighter policy.

So, what should the Fed do? The history of the past few years and the public’s weariness with persistent inflation mean that it can’t simply ignore the new shock of higher energy prices. At the same time, raising interest rates might not be a good idea given the fragile state of the labor market. Easing of tensions in the Persian Gulf and lower energy prices might help resolve the dilemma.

Until this happens, expect the Fed to sit on the sidelines.