Former Cleveland Fed Pres. Mester: The path of the Iran war will determine the path of the economy

Summary

• Loretta Mester states the path of the Iran war will determine the path of the economy, which in turn determines monetary policy, creating significant near-term uncertainty.
• An oil price shock, especially if coupled with a supply constraint like the Strait of Hormuz closure, typically creates upward pressure on prices (inflation) and downward pressure on growth and employment.
• The Fed is currently focused on the inflation risk from the oil shock, as inflation has been above target for five years and firms, having absorbed higher tariffs, may now be more willing to pass on higher energy costs.
• However, the downside economic pressure from an oil shock may be mitigated because the U.S. is now more energy-efficient and an energy-exporting country.
• Mester describes the labor market as in an "uneasy balance," with supply and demand balanced but at a low rate of hiring, making it vulnerable to a shock that could tip it into imbalance.
• Her current policy recommendation is for the Fed to "hold for now," assess risks, and be prepared to react as the situation evolves, as policy is currently at a good point for flexibility.
• She highlights that the Fed gathers critical real-time information beyond official data through direct surveys and conversations with its network of business advisory councils, which provides early indications of firm behavior (e.g., pricing intentions).
• A key data point to watch is whether firms start raising prices in response to higher energy costs, which would signal the shock is feeding into broader-based inflation.
• The central uncertainty is whether the oil price shock will remain a relative price change or become embedded in inflation expectations and broader price-setting behavior.