Trump's Tariffs and Iran War Could Force Fed Chair Kevin Warsh to Break a Pledge and Hike Rates This Week
Higher oil prices and trade wars are pushing the Fed toward its first rate hike since 2023.
The irony of the Federal Reserve's current situation is not lost on the markets. President Donald Trump has spent years publicly haranguing and harassing the central bank to lower interest rates. However, a direct line can now be drawn from the administration's policies to an inflationary environment that looks set to force the central bank to raise rates. This week, the credibility of the new Fed chairman, Kevin Warsh, faces its most significant test yet. Warsh, who was chosen by the President to lead the Federal Reserve, must navigate the complex intersection of political pressure and economic reality.
To understand the mechanics of this market move, one must define the term of art 'look through.' In central banking, to 'look through' means to ignore short‑term price spikes caused by supply shocks and focus on the underlying trend of inflation. In March of this year, one month after the start of the Iran war, the average Fed official was still forecasting rate cuts for the year and the next. The market priced in these cuts based on the assumption that the economic disturbances were temporary one‑offs. Six months later, that optimism has evaporated. Futures markets now predict a pivot away from cuts and toward hikes. At least three rate increases are priced in through March of next year. This shift represents a fundamental reassessment of the economic landscape.
The primary drivers of this inflationary pressure are two distinct but overlapping policy areas. First, there are the trade policies, specifically the tariff regime. Just last week, the President levied new tariffs on Canada in response to retaliatory tariffs. While these specific levies may seem small in isolation, they add to the cumulative pressure on the price of imported goods. The message to the Fed is clear. There is no guarantee that tariffs will be one‑offs in the Trump presidency. This uncertainty contributes to a higher baseline for inflation expectations.
The second driver is the geopolitical situation in the Middle East. The Iran war, which began six months ago, has destabilized energy markets. The situation has worsened with the temporary shutdown of the Saudi East‑West pipeline. This infrastructure issue limits the flow of crude oil, keeping supply tight. As a result, the Fed must consider that oil prices will not be falling quickly. The irony is that the President no longer responds to crude price increases with proclamations of an imminent deal with Iran. Instead, the focus has shifted to the practical impact on the economy.
This impact is visible at the pump. The surge in diesel prices to $6 a gallon threatens to push inflation deeper into the broader economy. Higher diesel costs do not stop at the gas station. They impact the cost of food distribution and transportation, creating a ripple effect that permeates the entire consumer price index. The President himself noted on Monday that diesel prices have risen more because of the war in Ukraine than the war in Iran. However, the specific mechanics of supply chain logistics mean that global conflicts compound each other. A situation that looks manageable in isolation becomes toxic when combined with other trade barriers.
In his speech at Jackson Hole, Wyoming, Warsh laid out the criteria for future policy. He stated that if the Fed was not confident that underlying inflation was declining, it would have 'work to do.' This statement serves as the framework for the week's decision. Warsh could gain that confidence if there is an apparent path to an end to the Iran war or some assurance that the President is satisfied with the current tariff regime. Until those assurances arrive, the central bank is forced to act.
The recent dissent by Minneapolis Fed President Neel Kashkari highlights the growing concern within the committee. Though Kashkari did not mention the President or his policies explicitly, his written statement provides insight into the internal debate. He initially believed that the Fed could 'look through' a one‑time rise in prices from a supply shock. Now, he writes that he 'increasingly believes that monetary policy does have an important role to play in addressing a series of successive supply shocks that might lead to entrenched higher inflation.' This is a crucial distinction. It moves the Fed away from treating shocks as temporary and toward treating them as structural threats to price stability.
Kashkari noted that this was the response of the Fed to successive shocks in the 1970s. 'Policymakers ultimately concluded that tight monetary policy was necessary to bring inflation back down despite their original supply shock diagnosis.' This historical precedent looms large for Warsh. The fear is that a failure to act now could leave the Fed playing catch‑up for years. The market is pricing in this risk, demanding a hawkish response.
The political pressure on Warsh is also a complicating factor. The President has forced Warsh's hand through public advocacy for rate cuts. By calling for cuts and picking a Fed chairman who seemed to be on board, the President undermined his own chair's credibility from day one. The proof of this came in Warsh's first congressional testimony. He noted that a sign of his independence came in his failure so far to cut rates as the President had desired. Now, the dynamic has shifted.
Warsh would be unlikely to hike solely because of the credibility issue. However, it could play a decisive factor if the economic data falls into a close call. Numerous Fed observers have noted that the chairman's reputation faces a test this week after his hawkish speech in Jackson Hole. 'Everything is pointing in the direction of September as a time to move if Warsh and his colleagues are going to maintain credibility,' former Vice Chair Roger Ferguson said on CNBC. The test is clear. The Fed must prove to markets that it is willing to risk a downturn and defy the administration to combat inflation, regardless of the political pressure.
It is never the Federal Reserve's place to judge administration policy as good or bad. Its only job is to assess their impact on the economy. On that basis, given recent developments in Iran and the Trump administration's actions regarding tariffs, it would seem difficult for the Fed to assess them as anything but leading to higher inflation in the months ahead. The credibility of the central bank rests on its ability to separate long‑term stability from short‑term political whims. This week, the numbers suggest the former is winning.
First reported by CNBC: Finance.
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