Rising US Inflation Risks: A Test of the Federal Reserve's Credibility

The Resurgence of Inflationary Headwinds: A Looming Threat to the US Economy

Accumulating Shocks and Doubts Over Control

Even as the Federal Reserve grapples with the aftermath of the previous inflationary cycle, a fresh wave of price increases appears to be on the horizon for the United States. The escalating geopolitical landscape, particularly the implications of the Iran conflict for global fuel costs, is fueling expectations that domestic prices will inevitably be impacted. Consumers, bond traders, and economists alike are now anticipating a significant jump in prices over the coming year. It's worth noting that skepticism regarding the Fed's credibility in achieving its 2% inflation target had already begun to surface even before the recent surge in energy prices, and prior to the appointment of a new chair tasked with a more accommodative monetary policy stance. A potential oil shock could further postpone the Fed's timeline for reaching its inflation objective, making the prospect of declaring "mission accomplished" increasingly distant. This has been a persistent issue for five years now, marked by successive price shocks stemming from global events such as the pandemic, the Russia-Ukraine conflict, tariffs, and now the current tensions involving Iran. While each of these events, viewed in isolation, might have been considered transitory, the cumulative effect of these short-term shocks could lead Americans to question whether the crucial "long-term goal" is a realistic endpoint or merely an elusive mirage.

Ethan Harris, former Global Chief of Economic Research at Bank of America Securities, aptly describes the risk of a prolonged oil shock as "the straw that breaks the camel's back." He elaborates, "After five years of elevated inflation, you're now facing a new wave of inflation." He emphasizes that even if this wave lasts only a few months, it could be sufficient to solidify the belief that "high inflation is here to stay."

The Impact of Recurring Energy Shocks on Inflation Expectations

In recent months, Federal Reserve officials have acknowledged growing market concerns about their commitment to the often-elusive inflation target. Late last year, Cleveland Fed President Loretta Mester referred to "discussions among market participants" who questioned whether the Fed would tolerate inflation rates slightly above 3%. She stressed that "getting inflation back down to 2% is critical for our credibility."

During an event in January, New York Fed President John Williams was asked about his comfort level with the Fed's own projection that inflation would not return to target until 2027, and how "realistic" it was to tame inflation. His response was unequivocal: "Completely realistic."

The Role of New Leadership in Restoring Confidence

A key figure in reinforcing this message will likely be the Fed chair nominee chosen by President Trump. Expected to take the helm from Jerome Powell in mid-May, though the timeline could shift, this nominee will need to convince investors of their willingness to act independently of President Trump, who insists inflation has been defeated and uses low interest rates to spur economic growth as a litmus test for his chosen successor. Since the end of last year, the Fed's preferred measure of consumer prices has hovered just below the 3% mark. Admittedly, this represents a significant decline from the post-pandemic peak of over 7%. However, this pullback has not been enough to make Americans forget the burden of high prices. A substantial portion of small business owners still cite inflation as their primary concern. In an election year, American voters consistently rank it as a top priority. All of this occurred before the geopolitical fallout led to a shock in prices – gasoline costs have already climbed by over 30%, and diesel prices by approximately 40%.

It is understandable, therefore, that Americans might feel they are experiencing a cascade of inflationary surprises, leading them to question whether this represents a new normal. In his post-meeting press conference last month, Fed Chair Powell was notably addressing this very issue.

Inflation Expectations: Between Economic Data and Consumer Reality

Powell stated, "The pandemic was a one-off event, right? This energy supply shock is also a one-off event." He went on to mention the surge in oil prices following the Russia-Ukraine conflict. "I don't know that the world has changed in a way that there will be more supply shocks," Powell remarked. However, he conceded, "In the last five years, we've seen more supply shocks than we saw in many years prior. That's a fact."

For central banks primarily focused on managing demand to combat inflation, these bumps in the road often present a quandary. Their recourse is to maintain confidence that the path will eventually level out, ensuring that one surge in prices does not spiral into another. In essence, this means anchoring long-term inflation expectations.

For the most part, the Fed has succeeded. Even during the most severe phase of post-pandemic inflation, some of the most closely watched indicators of long-term expectations in the bond market did not soar too high. In recent weeks, the 5-to-10-year breakeven inflation rate, which measures the difference between the yields on nominal Treasuries and inflation-protected Treasuries, has not deviated significantly from its average for 2025. As for consumers, last week's University of Michigan survey showed a jump in their price expectations for the coming year – but a slight decline over a 5-to-10-year horizon.

Concerns Over Fed Credibility and the "Risk" of Transitory Claims

In a Harvard event on Monday, Powell discussed the potential impact of the Iran conflict, stating that expectations "remain well-anchored beyond the short run" and that the Fed is closely monitoring these metrics. Nevertheless, Harris, the former Bank of America economist, suggests that the bond market indicators and economists' forecasts often align too closely with the Fed's own pronouncements, potentially indicating "a bit of blind faith." In contrast, he points out that consumer surveys, which actually shape the economy through behavior, point to higher inflation expectations, suggesting the Fed's credibility "has taken a bit of a hit."

Research indicates that public confidence in the Fed's ultimate victory in the inflation fight is crucial for dampening certain underlying shocks that could otherwise be worse. For instance, according to a study by the New York Fed, one reason why tariff hikes over the past year did not trigger broader price increases was that anchored expectations helped curb wage-hiking pressures.

Is Claiming "Transitory" Inflation Now Too Risky?

However, as above-target inflation persists, this belief may not endure. Fed research suggests there are signs that expectations might be more fragile than in the past. Officials are also issuing warnings.

Kansas City Fed President Michelle Bowman stated on Tuesday that inflation risks stagnating near 3%, and that "now is not the time to assume that inflation triggered by high oil prices is only temporary."

Last week, Philadelphia Fed President Susan Collins remarked that Americans have been contemplating and discussing prices for five or six years, leading to "an amplification of this sensitivity." She cited a "greater risk that higher fuel prices, higher fertilizer prices, are passed through to inflation expectations more quickly, and perhaps are somewhat more persistent." She noted that the widespread valuation differences appearing in household and business surveys are indicative of fragility when facing the next shock.

And with the recent Israeli strikes on Iran, that scenario is precisely what is looming. BNP Paribas economists wrote in a report last month: "Given all the events of recent years, can the Fed still sell the 'transitory' inflation story to the American public (and to itself)? Or will officials deem such an attempt too risky?"