Inflation threat may reignite? US-Iran conflict further reduces the likelihood of the Federal Reserve cutting interest rates!

Weekend attacks by the U.S. and Israel on Iran are undoubtedly causing turbulence in the oil markets. Many Wall Street analysts suggest these events could also reduce the Federal Reserve’s chances of cutting interest rates this year.

Data shows that after the U.S. and Israel attacked Iran, international oil prices surged on Monday morning, with Brent crude futures jumping 13% to $82 per barrel at the open, and WTI crude futures rising over 10% to $75 per barrel. Clearly, as trading resumed during the day, investors assessed global energy supply risks—especially the risks through the Strait of Hormuz (which carries about one-fifth of the world’s oil and liquefied natural gas)—leading to a panic-driven rally in oil prices.

RSM Chief Economist Joe Brusuelas pointed out that as Asian markets opened first, oil prices gapped higher, and investors initially favored the dollar assets for safe-haven purposes during the early stages of the conflict. If crude prices stay elevated, retail gasoline prices are likely to follow suit.

GasBuddy Petroleum Analyst Patrick De Haan said that the current national average gasoline price is about $3 per gallon. If crude costs continue to rise, this average could climb to $3.10–$3.15 in the coming weeks. For the Fed, this upward trend hits a particularly sensitive window.

Currently, U.S. inflation has been deviating from the Fed’s 2% target for nearly five years, and with tariffs beginning to pass through to consumers, price pressures are mounting. Service sector inflation, in particular, shows strong stickiness. As efforts to combat inflation stall, markets are steadily lowering expectations for rate cuts in 2026.

Analysts note that although energy prices are not included in the Fed’s preferred core PCE inflation index, policymakers often argue that monetary policy should not overreact to short-term volatility in energy prices. However, this strategy is more convincing when inflation is moderate and expectations are stable.

At present, market expectations are extremely fragile. Gasoline prices, as the most perceptible household expense, influence the overall outlook. After years of high inflation, the renewed rise in gas station prices can reinforce the public’s perception that inflationary pressures are deeply rooted. Once inflation hovers around 3%, dovish arguments for easing policy will seem increasingly weak.

This situation will also strengthen the voice of hawkish Fed officials, who have repeatedly warned against premature rate cuts.

Most Fed policymakers have made it clear that they need more concrete evidence of inflation returning to target before shifting policy. The rising oil prices undoubtedly give them more reason to maintain high interest rates and stay on the sidelines.

Capital Economics Chief Emerging Markets Economist William Jackson noted in a Saturday report that, based on historical rules of thumb, a 5% annual increase in oil prices typically raises inflation in major economies by about 0.1 percentage points. This means if Brent crude surges to $100 per barrel, global inflation could rise by 0.6–0.7 percentage points.

“This could slow the pace of monetary easing by major central banks, especially in emerging markets, where policymakers tend to be more sensitive to commodity price swings,” he added.

According to the CME FedWatch tool, investors further adjusted their rate expectations on Monday, reducing bets on a rate cut by the Federal Reserve in June. Currently, the probability of holding rates steady at the June meeting is 47%, up from 42.7% last Friday.

Of course, some argue that high oil prices essentially act as a “tax,” squeezing household budgets and raising business costs, which can dampen economic growth. This demand contraction, caused by reduced disposable income and squeezed profit margins, might cool demand-driven inflation to some extent.

This coexistence of “upward inflation pressures” and “downward growth risks” will likely put the Fed in a dilemma. Overreacting to energy costs could lead to excessive tightening, while ignoring them risks losing control of inflation expectations.

Many interest rate traders are already focusing on the earlier Fed rate decision this month—although the March policy statement did not directly mention Iran, it is highly likely they will emphasize geopolitical uncertainties and energy price volatility as potential risks.

Fortunately, today’s situation differs from the epic oil price surge triggered by Russia-Ukraine in 2022. Back then, global demand was rebounding rapidly from pandemic lows, and capacity was severely constrained; Iran’s energy exports are also much smaller than Russia’s, and the current global supply-demand balance is more resilient. Nonetheless, under the dual pressures of tariffs and service sector inflation, this supply-side shock significantly raises the likelihood of maintaining higher interest rates for longer.

(Article source: Caixin)