Federal Reserve officials continued on Friday that the US central bank may need to raise interest rates in the future if the war in the Middle East leads to a sustained increase in already high inflation. A possible shift in the outlook for monetary policy has also been acknowledged by Fed Vice Chair for Supervision Michelle Bowman, one of the central bank’s most unreliable policymakers. Bowman told a conference in Iceland on Friday that the war and the resulting energy shock could change her view on the outlook for rates.

“It is still too early to assess the size and persistence of economic impacts from the Iran conflict,” she said, however, “should the disruptions continue well into the second half of the year, we may begin to see broader effects on inflation.”

If that happened, Bowman noted, he would be more likely to “consider changing my approach to thinking about the balance of risks.”

She stopped short of saying that such an environment would require a rate hike. A number of Bowman’s colleagues are concerned that the current energy shock may be difficult to overcome as a temporary factor, especially since inflation has remained above the Fed’s 2% target for several years. With that view, these officials have indicated a willingness to consider raising rates to bring price pressures back in line. Financial markets believe the Fed’s next move will eventually be to raise its benchmark interest rate from the current 3.50%-3.75% range. Before the start of the US-backed war with Iran, which has caused massive disruptions in supply chains and spiked energy prices, Fed officials were eyeing a rate cut. Speaking to a business group in New Jersey, Philadelphia Fed President Anna Paulson said Friday that monetary policy is “well positioned” given unacceptably high inflationary pressures and economic uncertainty. Paulson added that the Fed is ready “to react,” and while she sees US monetary policy in the right place, “I think it’s healthy that market participants have accepted across the board scenarios where the (federal) funds rate remains unchanged for an extended period, as well as situations where further tightening becomes necessary.”

Worrying inflation data

Inflation risks are clearly rising for the Fed, at least in the near term. The New York Fed gauge is designed to capture the dynamics of underlying inflation, which rose to 4% in April from 3.5% in March, according to data released on Friday. Prices of non-housing goods and services increased in April compared to the previous month.

Additionally, data released by the US government on Thursday showed that the Personal Consumption Expenditures Price Index rose to 3.8% year-on-year in April from 3.5% in March.

Kansas City Fed President Jeffrey Schmid, speaking at the same conference as Bowman, said his “primary concern is inflation, which is very warm and has been above target for a very long time.” He added that the textbook strategy of going through energy shocks that would not have lasting effects was not practical at the moment.

Schmidt also nodded toward the possibility of using the Fed’s balance sheet to help put the brakes on price pressures.

“We’re not very restrictive at this point and I think there are some conversations that … need to start thinking about what tools we have to actually make it a little more restrictive depending on how the oil shocks play out.” “Maybe we see the balance sheet again as another tool … to create some restrictions,” Schmidt said, indicating some kind of new drawdown in Fed holdings could create the necessary headwinds for economic growth. His view on the balance sheet is likely to be at odds with Fed Chairman Kevin Warsh, who has expressed skepticism about using the central bank’s bond holdings to prop up its interest rate policy. Money market conditions and the Fed’s rate-control toolkit also limit how far it can shrink holdings without causing market volatility. The central bank is currently rebuilding liquidity after conditions tightened late last year.