Renewed US-Iran conflict sparks "inflation concerns": Soaring oil prices may raise US inflation rate by 0.7%. Can the Fed still cut interest rates?

The strikes by the US and Israel against Iran have pushed up oil prices, bringing the recently eased US inflation pressures back into focus for the market. If the oil price shock turns into a persistent supply disruption, the decline in inflation may be hindered, and the Fed's scope for rate cuts will also narrow.

On March 3, Brent crude hit $85 per barrel for the first time since July 2024, rising 9% in a single day. Diesel and gasoline futures rose simultaneously. Previously, US consumers, amid strong “stickiness” in food and other costs, could still rely on relatively cheap gasoline as a buffer, but this support is being weakened.

In terms of inflation, US CPI in January rose 2.4% year-on-year, cooling from 2.7% in December, partly thanks to gasoline prices falling 7.5% year-on-year. However, if crude oil continues to rise, gasoline prices may be transmitted to terminals within weeks, further raising costs for transportation and airfares, broadening the impact on overall price levels.

Neil Shearing, Chief Economist at Capital Economics, estimates that if oil prices rise to $100 per barrel over a long period, overall inflation could increase by about 0.7 percentage points. For investors, the key variables are the “intensity and duration” of the shock. JPMorgan CEO told CNBC on Monday that as long as the strikes don’t drag on, the inflation impact won’t be too big. Trump said on Monday that US actions in Iran are expected to last four to five weeks, “but we have the ability to last longer.”

How oil prices transmit to inflation: gas stations, transportation costs, and airfares

Gasoline prices are highly associated with inflation because the transmission chain is short, price updates are frequent, and competition is fierce. The US Energy Information Administration points out that crude oil prices are the largest single factor determining US gas station prices.

A commonly used economic rule of thumb is that every 5% increase in oil prices lifts year-on-year inflation indicators by about 0.1 percentage points. Single impacts may seem limited, but with sustained accumulation they visibly lift overall prices.

Rising oil prices spill over to other categories. The cost of trucking food and other goods rises, while pricier jet fuel pushes up airfare, thereby expanding the overall inflationary impact.

Two scenarios: limited impact from short-term disruptions; persistent rise lifts the inflation “step”

Many economists believe that if disturbances in the energy market are brief, inflation may be lifted for just one or two months. Last year, a 12-day conflict between Iran and Israel temporarily pushed oil prices up about $10 at the peak, and energy infrastructure was largely unaffected, so the price shock was short-lived.

Meanwhile, gasoline does not make up a large share of consumer spending. According to the latest government inflation report, gasoline accounted for only about 3% of average consumer spending in December, compared to 13% for food and more than a third for housing. This means that unless oil prices rise sharply and persistently, gasoline alone is not enough to “dominate” inflation over the long term.

But more dramatic scenarios are still being priced in. Harvard Business School economist Alberto Cavallo points out that if the Iran conflict leads to sustained crude oil gains, its impact may be reflected at gas stations within weeks, driving up overall inflation.

Neil Shearing, Chief Economist at Capital Economics, estimates that if oil prices rise to $100 per barrel over a long period, overall inflation could increase by about 0.7 percentage points.

Can the Fed still cut rates: energy shocks combined with existing price pressures makes the threshold higher

If the inflation path rises, it may be harder for the Fed to “ignore” the upward risks brought by energy. Neil Shearing believes that if inflation rises significantly due to oil prices, the Fed will become “even less willing” to lower short-term interest rates.

The policy backdrop is not “just energy” as a single variable either. Since the beginning of this year, with the labor market stabilizing and some price pressures remaining stubborn, the rationale for further easing by the Fed has weakened.

If potential energy shocks combine with last year’s tariff increases that are still working through the price chain, the Fed may be even more cautious about cutting rates.

Although the Fed often regards energy shocks as short-term disturbances, inclined to “wait them out” rather than react immediately, one of the key premises supporting its three rate cuts between September and December was near-term improvement in inflation. If oil prices push inflation back up, the threshold for further rate cuts will rise directly.

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