NextFin News - Philadelphia Fed President Anna Paulson warned on Friday that the escalating conflict in the Middle East poses a dual threat to the U.S. economy, potentially reigniting inflation expectations just as the central bank struggles to bring price growth down to its 2% target. Speaking at a macroeconomics conference in San Francisco, Paulson noted that while the U.S. has made "significant progress" in cooling the economy, the current inflation rate of 2.8% remains stubbornly above the Federal Reserve’s mandate. The risk, she argued, is that a prolonged war involving Iran could unanchor long-term inflation expectations, making the final stretch of the Fed’s tightening cycle significantly more difficult.
Paulson, who took the helm of the Philadelphia Fed in 2025, has established herself as a pragmatic centrist on the Federal Open Market Committee, often prioritizing data-driven caution over ideological hawkishness. Her background as a veteran researcher at the Chicago Fed has informed her focus on how "lifetime experiences" of high inflation can permanently alter consumer behavior. In her remarks today, she emphasized that if households begin to view 3% or 4% inflation as the new normal due to energy price shocks from the war, the Fed may be forced to maintain higher interest rates for much longer than markets currently anticipate.
The geopolitical situation has already begun to ripple through global energy markets, with Brent crude futures hovering near $95 a barrel. Paulson pointed out that these supply-side shocks are particularly dangerous because they hit "high-frequency" purchases like gasoline and groceries, which have a disproportionate impact on how the public perceives future price trends. She suggested that the long-run federal funds rate might now need to settle at approximately 3.1%, a notch higher than previous estimates, to account for a more volatile global trade and security environment.
However, Paulson’s cautionary tone is not yet the consensus view within the Fed or among private-sector economists. Several analysts at major Wall Street firms have argued that the U.S. economy’s resilience—bolstered by a strong labor market and domestic energy production—provides a sufficient buffer against overseas shocks. These skeptics suggest that unless the conflict leads to a total closure of the Strait of Hormuz, the inflationary impact may be transitory. They point to the fact that five-year inflation break-evens, a key market-based measure of expectations, have remained relatively stable despite the headlines.
The tension in Paulson’s outlook lies in the "unpredictable nature of wartime economics." She cautioned that the Fed cannot afford to be complacent, as the psychological shift in inflation expectations often happens "slowly, then all at once." If the war expands, the resulting supply chain disruptions could collide with a U.S. fiscal policy that remains expansionary under U.S. President Trump, further complicating the central bank's mission. For now, Paulson’s stance serves as a reminder that the path to a "soft landing" remains narrow and fraught with external risks that no amount of domestic interest rate tweaking can fully control.
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