The Fed's Best Response to the Iran Conflict Is to Follow Monetary Rules

Jai Kedia

The Federal Reserve held rates steady at its March meeting, keeping the target for the federal funds rate at 3.5 to 3.75 percent. It was an unsurprising decision, but the environment surrounding it was anything but routine. An active conflict in Iran is driving energy prices higher. While the Fed does not directly respond to the volatile energy sector, increased oil prices are likely to bleed into the prices of goods and services that the Fed does care about. The Iran conflict is just the latest complication in an already murky economic outlook—one that includes ongoing tariffs, political pressure on the Fed, and uncertain productivity gains from AI. Taken together, the Fed now faces one of the harder monetary policy problems in recent memory.

How the Fed responds to Iran matters. But the framework it uses to reach that response will have consequences well beyond this episode. The discretionary approach that the Fed is currently signaling is, unfortunately, the approach most likely to go wrong. The better path is rules-based monetary policy: not because it is perfect, but because it is consistent, predictable, and objective policymaking.

Supply shocks, such as unexpected oil price surges, are uniquely difficult for central banks. Unlike demand shocks, in which inflation and output move in the same direction and the recommended policy response is to lean in the other direction, supply shocks force a trade-off. Tighten too much to contain inflation, and you risk compounding the damage from reduced output. Ease too much to cushion growth, and you risk embedding the price spike into longer-run expectations. Hold steady, and you are implicitly betting that the two effects will offset each other.

The third option of holding steady is known as “seeing through” supply shocks and is the commonly favored approach. It seems prudent but still rests on a claim the Fed cannot substantiate: that it knows, with sufficient precision, the supply shock’s upward pressure on inflation will be offset by its downward pressure on output. That requires knowing the shock’s duration, how much it contributes to higher core inflation, its ripple effects on consumer spending and business investment, and how all of those interact. (Not to mention being able to disentangle all the other shocks affecting the economy at the same time.) 

The Fed made a version of this error when it judged post-pandemic inflation to be transitory and held policy too loose for too long. Although not entirely the Fed’s fault, prices did not remain stable, and ordinary Americans suffered. Among the major reasons for the Fed’s failures was its reliance on increased discretionary policymaking and placing too much faith in its own ability to accurately assess economic conditions. The current situation is not identical, but uncomfortably similar.

To be fair, at his press conference following the latest rate decision, Fed Chair Jerome Powell repeatedly expressed doubts over the accuracy of the Fed’s economic forecasts, asking reporters to “to take the forecast[s] with a grain of salt” as they are “subject to just very high levels of uncertainty.” The concerning part is that the Fed’s projections of interest rates do not seem to be affected by this uncertainty, despite us being assured that monetary policy is “not on a preset course.” 

The Fed’s most recent “dot plot”—its quarterly summary of where each Federal Open Market Committee (FOMC) member and the remaining five regional bank presidents expect rates to be in the future—showed that not a single forecaster viewed a rate hike as appropriate for the rest of 2026. This view comes despite inflation consistently running above the Fed’s 2 percent target, upward revisions to inflation forecasts, and a relatively unchanged unemployment rate. In fact, the median projection suggests rates will be 25 basis points lower by the end of the year. 

These projections are so detached from macroeconomic data that it seems the FOMC has once again decided to rely on discretion and its own “reading of the tea leaves” to chart a course for monetary policy. Even more concerning is that the committee’s assessments seem to mirror its post-pandemic mistakes, in which, under the pretext of “seeing through” supply shocks, it left rates unchanged even as data suggested doing otherwise. Markets, however, did not wait around for the Fed to update its views. Betting markets now think the chance of a rate hike in 2026 is over 20 percent, and poor bond auctions have already started raising Treasury yields. Given the Fed’s recent failure curbing inflation, coupled with the constant pressure by the administration to keep rates low, the Fed seriously risks unmooring long-term inflation expectations.

All of this mess is avoidable and precisely what rules-based monetary policy is designed to solve. The Fed should commit to following a monetary policy rule—an arithmetic formula connecting the interest rate target to values of macroeconomic indicators. These rules offer better macroeconomic performance while minimizing the fallout from the Fed’s subjective reading of the economy. Commonly accepted rules recommend raising rates to counter inflation but lowering them to counter poor employment or output data. Thus, they have a built-in tendency to “see through” supply shocks, but only if the data warrant it. Moreover, in our current uncertain economic environment with war and competing shocks, rules seriously lower the information burden on the Fed. The 12 FOMC members should not be expected to perfectly calibrate the economy, especially now, and following a policy rule is likely the best any central bank can do.

Importantly, Cato research has shown that the specific rule chosen matters less than the commitment to following one consistently. No rule is perfect, but all of them are transparent, verifiable, and insulated from the real-time pressures that distort discretionary judgment. The Fed’s credibility is built not on being right every time but on being predictable and consistent. Rules provide that. Discretion, by its nature, cannot. Virtually all commonly accepted rules would have helped the Fed better handle post-pandemic inflation. And most would have the Fed in better unison with private markets now.

The Iran conflict is a test of whether the Fed has learned from its post-pandemic mistakes. The Fed cannot fix bad foreign policy, trade policy, or fiscal policy. At best, it can respond in a consistent and predictable manner to keep markets and expectations anchored. Rules-based monetary policy is the way to do that.