Prices are soaring! The U.S. economic engine adds another scar—how will the Federal Reserve weigh its options?

Influenced by rising oil prices, the US CPI for March released this week is expected to surge by 3.5% year-on-year.

Latest data shows that, as the largest component of the US economy, the service sector’s growth in March has slowed down, due to the Iran-US conflict pushing up business costs, while companies respond by cutting back on employment. This indicates that before the conflict ends, the US economy will face a more challenging development path, and with inflation and employment both under pressure, which side will the Federal Reserve’s policy balance tilt toward?

Spread of Middle East conflict impact

Data released Monday by the Institute for Supply Management (ISM) shows that the service sector business activity index, covering banks, retailers, and restaurants, fell from 56.1% last month to 54% in March. The February reading was the highest in three and a half years.

Boosted by weather factors, the new orders index rose from 58.6 in February to 60.6, reaching the highest level in three years. On the downside, the price index measuring inflation soared to its highest since October 2022, with a monthly increase of the largest in 13 years. Due to partial closure of the crucial shipping channel, the Strait of Hormuz, along Iran’s coast, costs for oil, fertilizers, and other key chemicals surged significantly.

Companies’ responses include controlling hiring or leaving positions vacant. The employment indicator turned into contraction territory for the first time in four months, contrasting sharply with the US official March employment report, which showed a significant increase in hiring.

Middle East geopolitical conflict has become a core topic in ISM report comments. Companies across industries, from construction to wholesale trade, have indicated that the conflict adds an extra layer of uncertainty. Before the outbreak of war, companies were already dealing with uncertainties caused by import tariffs.

However, any index value above 50 still indicates business expansion. The index has remained above this critical threshold for 21 consecutive months. Looking ahead, the continued strong growth of new orders suggests that, supported by stable domestic sales, the large service economy may continue to expand at a rate above the average. Over 80% of Americans are employed by service companies. The service sector is relatively less affected by global crises because its business is mainly domestic.

Notably, data released last Friday by S&P Global also showed that the US Services PMI dropped from 51.7 in February to 49.8 in March, marking the first contraction since January 2023, well below the preliminary reading of 51.1. Besides the rising price index, employment figures slightly declined for the first time since December last year, reflecting cautious outlooks among companies. “The service sector dragged the overall March economic growth rate down to nearly stagnant at 0.5% annualized. The most severely impacted is the consumer-facing service sector, which, excluding pandemic lockdown periods, experienced one of the worst declines since 2009,” said Chris Williamson, Chief Business Economist at S&P Global Market Intelligence.

How the Fed will decide

These Monday surveys reinforce Wall Street’s expectations — that the Federal Reserve will keep interest rates unchanged for a long period. Fed funds futures pricing indicates that the rate cut window may not open until the second half of next year.

Priscilla Thiamagurti, senior economist at BMO Capital Markets, said, “The service sector is still expanding, but resistance is increasing. With softening employment and rising inflation pressures, data shows economic growth slowing and price stickiness intensifying. This puts the Fed in a dilemma and strengthens the case for patience.”

The US and Iran conflict has already pushed global oil prices up by over 50%. Since last week, the average retail gasoline price in the US has surpassed $4 per gallon for the first time in nearly four years. Economists expect that the inflation shock caused by the war will be reflected in the March Consumer Price Index (CPI) report to be released on Friday.

In a research report on the upcoming CPI, BNP Paribas in Paris noted, “We believe the first-round transmission of rising oil prices will be reflected in March data through vehicle fuel costs.” A summary by Yicai.com found that Wall Street currently expects the March CPI to rise 0.9% month-on-month and accelerate to 3.5% year-on-year; core CPI, excluding energy and food prices, is expected to increase 0.3% month-on-month.

Notably, two Federal Reserve officials expressed concerns about inflation in their latest speeches last Wednesday. Cleveland Fed President Loretta Mester and Chicago Fed President Austan Goolsbee both believe that inflation is a much more serious issue than employment. Against the backdrop of rising energy prices due to the Iran war and a persistently sluggish labor market, their statements highlight their support for tightening rather than loosening monetary policy.

John Raiden, chief economist at Brean Capital, said, “If it weren’t for the March employment data, the employment decline would be more worrying. The ISM payment prices are a very useful indicator of inflation trends, and this data should worry the Fed, especially given the inflation rate approaching 4%.”