The war in Iran is complicating an already difficult inflation picture for the Federal Reserve, and potentially pushing rate cuts further into the future.
Oil prices have surged more than 15% since U.S. and Israeli strikes killed Iran’s Supreme Leader Ali Khamenei on Saturday, and gas prices in the U.S. have increased alongside them.
Iran has effectively closed the Strait of Hormuz, which handles 20% of global oil flows, and bond markets look like they’re pricing in inflation. The 10-year Treasury yield topped 4.06% Tuesday as the Dow fell about 1,200 points before recovering some of its losses.
Rate markets are factoring in fewer cuts this year. The Fed was likely going to hold rates steady in March, but investors are now questioning if they’ll hold all year.
Three Fed officials spoke publicly Tuesday, and none of them sounded like they were in a hurry to cut.
Minneapolis Fed President Neel Kashkari, speaking at a Bloomberg Invest conference, said that the Fed would have to rethink its policy stance because of geopolitical events.
“The question I think that we are wrestling with, and markets are wrestling with, is, how long is this going to last?” he said. “How bad is it going to get? Is it going to look more like Russia-Ukraine, or is it going to look more like Hamas attacking Israel, and that’s going to have effects on monetary policy.”
Those two conflicts produced opposite outcomes. The Russia-Ukraine invasion sent commodity prices soaring and contributed to the worst inflation in four decades, one Kashkari said the Fed misjudged after initially expecting it to be short-lived. Conflict in Israel and Palestine, meanwhile, didn’t produce a meaningful energy shock.
“A renewed burst of inflation—akin to what we saw in 2022 and 2023 in the fallout from the Russia-Ukraine War—could upend global growth this time,” wrote Thierry Wizman, global FX & rates strategist at Macquarie Group. That’s because AI-based technologies depend upon cheap energy and electricity.
“The scene may also be littered by renewed hawkishness among central banks, should the War be lasting,” he said.
New York Fed President John Williams told reporters at a credit union conference in Washington that the fallout hinges on how long they affect asset prices, especially the price of oil. He echoed Kashkari’s concerns about timing. “We’ll have to see how persistent this is,” he said.
Kansas City Fed President Jeff Schmid, speaking in Denver, said that “inflation has been above the Fed’s objective for nearly five years now. I don’t think we have room to be complacent,” indicating that hikes could now be on the table, not just a prolonged pause.
The Fed typically looks through oil price shocks because they’re considered supply-side hits to headline inflation, not demand-driven spirals.
“It’s doubtful that the Fed would hike rates to address inflation worries that result from a spike in oil prices,” said Jack Janasiewicz, lead portfolio strategist at Natixis Investment Managers Solutions. The pass-through from oil to core inflation, he said, “tends to be much more muted.”
But this oil jump isn’t landing in an economic void. Inflation was already running around 3% before the strikes, held up partly by tariff-driven goods price increases.
The oil surge, said Citigroup analysts, “is not happening in isolation.” It follows industrial commodity prices for steel, aluminum, and copper already moving higher.
“The key question now is whether core goods inflation will slow as consensus expectations had expected,” the analysts wrote in a note Tuesday, “or if core goods will become a more persistent source of inflationary pressure over the remainder of the year.” Core inflation doesn’t include the price of food or energy.
Kashkari made note of that risk on Tuesday.
“Even when you strip out food and energy, they do eventually affect core, because energy goes into producing core goods and services as well,” he said. “If headline inflation is going to be elevated for an extended period of time, coming off of five years of elevated inflation, that’s a scenario that we need to pay close attention to.”
Nationwide chief economist Kathy Bostjancic said that even a moderate disruption, like Brent crude averaging $80 a barrel for a quarter would add about 0.6 percentage points to annual CPI and shave 0.5% off annualized GDP growth.
“Coming into this moment, I was feeling pretty good,” Kashkari, a voting member of the FOMC this year, said. “Now we need to see about this potential new shock hitting the global economy.”
