Fed officials say Iran war obscuring outlook as traders price in rate hike

* Fed officials express caution due to Iran war's impact on energy prices

* Bowman advocates for more interest rate cuts to support labor market

* Iran war uncertainty affects Fed's economic, policy outlook

By Michael S. Derby and Howard Schneider

NEW YORK, March 20 (Reuters) - The risk of persistent inflation arising from the escalating war with Iran was strong enough to convince an influential Federal Reserve policymaker to switch his support to keeping interest rates on hold from cutting them this week, he said on Friday, as market expectations for the U.S. central bank's next move shifted rapidly toward a hike in borrowing costs. "We don't know where this is going to go, but we have to sort of think maybe caution is warranted" for the U.S. central bank, given the recent surge in energy prices, Fed Governor Christopher Waller said in a CNBC interview.

Noting that many oil price shocks usually involve a surge and then a subsequent pullback, the Fed is watching to see if prices surge and stay high, as that poses the most notable risk to drive up inflation that's already above the central bank's 2% target, he said.

If high energy prices start pushing up underlying rates of inflation, "you do have to kind of respond," Waller said. But for now, "I just want to wait and see where this goes, and if things go reasonably well and the labor market continues to be weak, I would start advocating again for cutting the policy rate later this year," Waller said, adding that he didn't see any need to consider raising borrowing costs, as some Fed officials are now contemplating.

In a separate interview with Fox Business Network's "Mornings with Maria" program, Fed Vice Chair for Supervision Michelle Bowman said "it's too early to tell what the longer-term imprint will be on the U.S. economic activity, and how we should think about that in terms of our longer-term economic forecast, and how we should think about that in terms of our (policy) meetings and any rate changes that we might make as a result of economic evolution coming forward."

UNCERTAINTY IN DRIVER'S SEAT Waller and Bowman were the first Fed policymakers to speak publicly since the U.S. central bank decided on Wednesday to leave its benchmark overnight interest rate in the 3.50%-3.75% range following the end of a two-day policy meeting. The Fed's policy statement flagged the uncertainty that the U.S.-Israeli war with Iran was creating for the economic outlook.

Updated economic projections released by the Fed on Wednesday showed policymakers continuing to pencil in a single quarter-percentage-point rate cut this year and another such move in 2027.

Traders of short-term interest-rate contracts, however, are now pricing in increased odds of a rate hike in December, a dramatic shift from expectations earlier this week of a reduction in borrowing costs. Bank of America economists said to hike rates, the job market should be stable with an unemployment rate of around 4.5% and core inflation as measured by the Personal Consumption Expenditures Price Index should exceed 3.2%, among other factors.

"These conditions are most likely to be met if the Iran shock is sustained but moderate" and the "sweet spot" for hikes has oil in the $80 to $100 per barrel range, they said.

A Dallas Fed report said "a closure of the Strait of Hormuz that removes close to 20% of global oil supplies from the market throughout (the) second quarter (of) 2026" should raise the price of oil to just shy of $100 per barrel. The volatile surge in energy prices triggered by the war and the uncertainty about the flow of oil and natural gas from the Middle East creates the risk of higher inflation, slower economic growth and job losses, as consumers are forced to spend more on energy. That outlook creates a significant challenge for Fed policymakers because it threatens the central bank's job and inflation mandates, potentially forcing them to choose which to emphasize. Meanwhile, some Fed policymakers are contemplating the need for rate hikes. The case for hiking rates rests in part on the reality that the central bank has missed achieving its inflation target for years, which threatens to erode public confidence that price pressures will return to target.

Some Fed policymakers also are concerned about the already-tepid labor market.

Bowman did not say what she expects the Fed to do over the near term, but noted in her interview that "I'm still concerned about ... the job market" and in terms of the monetary policy outlook, "I've written three cuts in ... before the end of 2026, to hopefully support the labor market." Bowman's decidedly dovish monetary policy outlook contrasts with that of many of her Fed colleagues. (Reporting by Michael S. Derby; Editing by Chizu Nomiyama and Paul Simao)