Will inflation cool when oil prices fall? Fed officials say "no"

Thursday (May 28) Asian session, the United States and Iran on the issue of the reopening of the Strait of Hormuz continued to affect the international oil prices after yesterday's sharp decline after a slight rebound, the current US crude oil futures rose 2% to $90.48/barrel, Brent crude oil rose more than 1% to $94/barrel.

On Wednesday, international oil prices suffered a sharp sell-off. US crude oil futures fell by more than 5% to below $88, and Brent crude oil fell by more than 6% to below $92. The immediate trigger was the progress of peace talks between the United States and Iran. The market expected that the Strait of Hormuz could resume normal navigation within a month, and the geopolitical risk premium quickly faded. However, the drop in oil prices did not shake the Federal Reserve's vigilance against inflation.

In a speech at Stanford University on Wednesday, Lisa Cook, the Federal Reserve governor, gave a clear warning about the current state of US inflation, noting that while inflation had fallen back over the past year, she was concerned by recent data suggesting it was moving in the wrong direction.

"After five years of above-target inflation, I am particularly wary of the risk that high inflation could embed itself in price and wage-setting behaviour," Ms Cook stressed in her speech. "I am ready to raise interest rates if the expected deflation does not materialise in time." She further explained that once inflation expectations became unstable, the Fed would have to take stronger measures to restore price stability.

Short-term shocks could affect medium-term inflation

While she expected inflation to ease in the coming months, Ms Cook cautioned her audience against ignoring the potential impact of even temporary shocks, arguing that short-term price pressures, if sustained long enough or interpreted by market participants as structural changes, could have a more profound impact on medium-term inflation movements.

She points out that companies may embed higher energy costs in their pricing, especially in industries with stronger pricing power, making it easier to pass on upstream costs to consumers. At the same time, workers will also include them in wage negotiations, creating the risk of a "price-wage" spiral, which is the inflation self-reinforcing mechanism that central banks are most wary of.

Artificial intelligence and utility prices are also pushing up inflation

Cook further pointed out that the driver of inflation is not limited to the energy sector. She stressed that in addition to rising energy prices, large-scale investment in artificial intelligence could also contribute to inflationary pressures in multiple channels. While artificial intelligence may increase productivity and lower costs in the long run, in the short term, the concentrated construction of related infrastructure is driving up the prices of certain goods and services.

Specifically, she noted that the prices of chips, other high-tech equipment and software, which are core inputs to the development of artificial intelligence, have risen significantly. In addition, the huge demand for electricity and cooling water in data centers and artificial intelligence model training is also driving up utility prices - electricity and water prices have each risen by about 5% in the past year, putting additional upward pressure on overall inflation.

Benchmark scenario: Inflation can come down without raising interest rates

Despite her warnings about inflation risks, Ms Cook's baseline outlook remains relatively upbeat, and she made clear in her speech that based on current data and modelling analysis, she expected inflation to gradually fall back to closer to target over the next few quarters without the need for further Fed rate rises.

At the same time, she expects the job market to remain stable without cutting interest rates. Cook believes that the current labor market is achieving a better balance - fewer job openings, a recovery in labor force participation, and slower wage growth - all of which are helping to reduce inflation without sacrificing employment. She stressed that the Fed's goal is to achieve a "soft landing", that is, to control inflation while avoiding a recession.

Inflation data to be released soon: PCE may rise to nearly 4% in April

Mr. Cook's comments came at a crucial time ahead of the release of the price index for personal consumption expenditures (PCE), the Fed's favourite measure of inflation. The data, due to be released by the commerce department on Thursday, is being watched closely by market participants for confirmation of Mr. Cook's judgment about the direction of inflation getting worse.

Overall PCE inflation is widely expected to rise from 2.7 per cent in March to almost 4 per cent, driven by a sharp rise in energy prices in April. The "core" PCE, which strips out energy and food prices - a better indicator of underlying inflation trends - is expected to rise 3.3 per cent in April.Forex PlatformThat would be the highest reading since 2023, adding to fears that inflation could be too "sticky".

Kashkari: Inflation risk has outweighed employment risk

Neil Kashkari, president of the Minneapolis Fed, expressed similar concerns about the inflation situation during a question-and-answer session in Japan on Wednesday, making clear that the Fed needed to rein in what appeared to be rising inflation risks and could not take them lightly.

But he also cautioned that it was too early to tell whether this would require a rate hike. However, Kashkari made a noteworthy trade-off judgment: he pointed out that in the current economic environment, the risk of rising inflation has outweighed the risk of a deterioration in the labor market. This statement means that the Fed's monetary policy focus may be shifting from "balancing inflation and employment" to "more emphasis on controlling inflation".

The "inflationary shock wave" of the US-Iran conflict may continue

Mr. Kashkari also singled out the potential impact of geopolitical factors on the US inflation outlook, warning that the "inflationary shockwaves" sent around the world by the US-Iran conflict were likely to persist and would not fade quickly in the short term.

He further explained that this shock is transmitted to the US economy mainly through the impact on energy prices. If conflict in the Middle East persists or escalates, oil and gas prices could remain high or even rise further, which would directly drive up the costs of various economic sectors such as transportation, manufacturing, and heating. More importantly, persistently high energy prices could change business and consumer expectations for long-term inflation, making the inflation problem more entrenched.

Market reaction: 2-year Treasury yields remain high

The bond market has reacted clearly to the Fed officials' comments and the latest inflation outlook, with the yield on the two-year US Treasury, one of the most sensitive leading indicators of the Fed's interest rate policy, holding steady at around 4 per cent this week.

This yield level has important policy implications: it is 25 basis points above the upper end of the Fed's current target range for policy rates of 3.5-3.75 per cent. In the language of the bond market, this means that investors are pricing in higher long-term inflation and are already anticipating that the Fed may have to raise rates one more time this year - a sharp contrast to the "multiple rate cuts during the year" widely expected at the start of the year.

Taken together, while Ms Cook still prefers to keep interest rates on hold, she has expressed clear concerns about the direction of inflation and kept the option of raising rates open, while Ms Kashkari has been more direct in pointing out that inflation risks have outweighed employment risks, while warning of a sustained inflationary shock from geopolitical conflict. Meanwhile, the market has priced bond yields to reflect expectations of a rate hike this year, reversing expectations of a rate cut at the beginning of the year. Overall, the Fed's tone is shifting from "preparing for rate cuts after inflation falls" to "patiently but prepared to deal with inflation rebounds".