The surge in oil prices is causing a wave of "supply-side" inflation that the Federal Reserve may be unable to counter with its main inflation-fighting tool.

The Fed usually raises its fed funds rate to curb "demand-side" inflation stemming from consumers holding more cash, but that is thought to be ineffective against inflation driven by supply shortages.

The Fed may raise rates after all if the shock continues for a long time, leading the public to expect higher inflation in the future.

The Iran war is causing a surge in energy prices that's likely to stoke inflation in the coming months, and the Federal Reserve's monetary policy playbook may be helpless to stop it.

With average gas prices up more than $1 a gallon so far because of the Iran war, economists say other prices are likely to follow suit and lead to a general uptick in inflation. Forecasters at Bank of America, for example, said they expect consumer prices as measured by Personal Consumption Expenditures to rise nearly 4% over the year in the second quarter, up from their pre-war estimate of 3% annual inflation.

The Federal Reserve, tasked by Congress with managing inflation, would normally raise its key interest rate to counteract the uptick. But the kind of inflation we're experiencing may not be the type the Fed can control with its monetary policy, according to Fed Chair Jerome Powell and some economists.

If Fed officials view their policy as ineffective against the current wave of inflation, they're more likely to hold the central bank's key interest rate steady in the coming months even if prices start rising significantly. The federal funds rate influences borrowing costs on all kinds of loans: raising it tends to discourage spending, while lowering it can promote spending and boost the economy and the job market.

Economists generally view inflation as arising from one of two main causes: demand or supply.

In demand-side inflation, consumers have lots of money in their pockets and spend more freely, so demand for goods rises, but supply is not enough. The Fed can curtail demand by raising the fed funds rate, making loans more expensive.

In supply-side inflation, some important item becomes scarce, leading customers to bid up prices. The restriction of oil and other supplies from the Middle East is causing a supply-side shock to prices for energy and some other key resources such as fertilizer and aluminum.

The Fed may "look through" the energy price shock and keep interest rates steady for some time rather than reacting by raising rates. Higher rates would discourage spending and slow the economy.

The problem for the Fed is that it views rate hikes as effective against demand-side inflation but less so when inflation is driven by shortages. The Fed can effectively create money out of thin air, but not crude oil. Powell addressed the issue this week during a Q&A session at Harvard.

"When you have a supply shock, our tool doesn't have meaningful shorter-term effects on supply," he said.  "Energy shocks have tended to come and go pretty quickly. Monetary policy works with long and variable lags, famously. And so by the time the effects of a tightening in monetary policy take effect, the oil price shock is probably long gone and you're weighing on the economy at a time when it's not appropriate. So the tendency is to look through any kind of supply shock."

Powell's comments prompted traders to pare bets on a rate hike at some point this year. As of Wednesday, there was less than a 2% chance of a rate hike by December, down from an 18.5% chance a week ago, according to the CME Group's FedWatch tool, which forecasts rate movements based on fed funds futures trading data.

If the Fed overlooked the inflation uptick, it wouldn't be the first time. Economists at Goldman Sachs, analyzing speech transcripts, found no correlation between oil price shocks and intentions among Fed officials to raise the fed funds rate.

"The Fed typically does not tighten in response to oil shocks alone," Manuel Abecasis, an economist at Goldman, wrote in a commentary.

That could change, however, if the oil shock lasts long enough to cause consumers to expect future high inflation. Inflation expectations can become a self-fulfilling prophecy, according to the conventional economic wisdom, at which point the Fed might step in with rate hikes.

"You can have a series of these supply shocks and that can lead the public generally—businesses, price-setters, households—lead them to start expecting higher inflation over time," Powell said. "Why wouldn't they? At the end of a certain number of years, the inflation is now just higher, and that can happen. So you monitor that very, very carefully."

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