Author: Nicole Goodkind; Translated by: Barrons
Original Title: Israel-Iran War Escalates Inflation Risks, Federal Reserve Closely Monitoring Situation
The escalation of tensions in the Middle East is driving up oil markets and inflation expectations, making it more challenging for the Federal Reserve to balance its goals of price stability and full employment, especially as officials prepare for next week's meeting.
Uncertainty around tariffs has already made Federal Reserve decision-makers cautious about interest rate decisions, and now oil market volatility is likely to make them even more hesitant.
After Israel's military action against Iran's nuclear facilities and military targets, oil prices surged, with Iran immediately launching a drone and missile counterattack, raising concerns about further conflict. Oil prices initially rose over 13% on the news, though they later receded, with analysts believing prices may remain elevated for some time.
"The rise in geopolitical uncertainty means energy markets must factor in a higher risk premium for potential supply disruptions," analysts from ING wrote in a Friday report. They warned that if shipping through the Hormuz Strait (a chokepoint for nearly one-third of global oil trade) is disrupted, Brent crude prices could spike to $120 per barrel. Currently, Brent crude is slightly below $75 per barrel.
Even in a moderate scenario, rising energy prices could keep inflation rates high for a longer period and force the Federal Reserve to maintain higher interest rates. ING analysts wrote that "the oil price surge could break the current narrative about US inflation—despite US tariffs, inflation has remained more moderate than expected". They stated that while commodity price inflation is currently relatively stable, "we anticipate more significant monthly inflation data increases throughout the summer."
These concerns are already reflected in market volatility. "If this situation is not quickly resolved, it will certainly impact inflation data," wrote Louis Navellier, founder of Navellier & Associates, on Friday. He noted that the government bond market "seems to be reacting more to inflation threats than to the possibility of a third world war."
On Friday, 2-year and 10-year US Treasury yields both rose.
The surge in energy costs could potentially increase short-term inflation expectations among investors and the public, creating a potentially self-reinforcing dynamic that might compel the Federal Reserve to take action.
Joe Brusuelas, chief economist at RSM, wrote in a report: "The primary risk to the interest rate outlook is inflation expectations becoming unanchored. If consumers push short-term inflation expectations higher, the Federal Reserve can almost certainly delay rate cuts until December at the earliest, or even postpone them until next year."
Federal Reserve officials are expected to maintain interest rates unchanged throughout the summer. The latest geopolitical developments may further solidify this view. However, Brusuelas warned that a combination of "tariffs and oil-driven price shocks" could prompt a policy shift, causing the Federal Reserve to further delay or even increase rates.
Currently, the Federal Reserve seems more inclined to remain passive and observe. Brusuelas stated, "Given new tariffs and rising energy prices, the Federal Reserve should temporarily wait and take no action until the current volatility subsides."
According to the CME FedWatch tool, the market currently anticipates two rate cuts totaling 0.5 percentage points by the end of 2025.
The Federal Reserve's next meeting will be held on June 17-18, with the market widely expecting this to be the fourth consecutive time rates remain unchanged.
