Tensions in Iran push up oil prices, and the Fed's room for rate cuts this year is "disappearing."

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The combination of rising oil prices and tariff pressures is sharply reducing the Federal Reserve's room for maneuver in monetary policy. Several economists have warned that if the U.S. takes military action against Iran, the inflation outlook will deteriorate further and the possibility of a Fed rate cut this year may be completely dashed.

As tensions between the U.S. and Iran have escalated, WTI crude oil futures have risen about 16% so far this year, with the price per barrel up about $10 since the start of the year. Boston College economist Brian Bethune told the media, "The reasons to support rate cuts are vanishing before our eyes." He pointed out that the rise in oil prices, combined with the Trump administration's aggressive tariff policies, are putting upward pressure on inflation, making the decision to lower interest rates increasingly complicated.

Traders in the derivatives market still expect the Fed to cut rates twice this year, each by 25 basis points, with the first cut in June and the second in September. However, several analysts believe that geopolitical risks could make such expectations hard to realize. BMO Capital Markets Chief U.S. Economist Scott Anderson warned that if the conflict persists, the Fed's next move could even be a rate hike.

Inflation pressures are heating up before rate cuts

Even before the Iran situation escalated, U.S. inflation data had already started showing rebounds that made the Fed uneasy.

Wholesale prices began accelerating last December and are now rising at an annual rate of 3%. Ethan Harris, former Chief Economist at BofA Securities, noted in a LinkedIn report that higher producer prices are very likely to be passed on quickly to consumers.

Anderson said that in the first quarter of this year, inflation appears to be heating up. The core Personal Consumption Expenditures (PCE) price index may rise to an annual rate of 3.1% in January, its highest level in nearly two years—even before the U.S. might take action on Iran. The Fed's inflation target is 2%.

He estimates that every $10 increase in oil prices will push consumer price inflation up by 0.2 to 0.4 percentage points over the next year. Given that oil prices have already climbed about $10 this year, the impact cannot be ignored.

"Even just the increased risk of conflict with Iran is already shocking energy markets and prices, exacerbating U.S. inflationary pressures, and creating major obstacles to further Fed rate cuts," Anderson said.

Tariffs and oil prices are both supply-side shocks, hard for monetary policy to address

Economists point out that what makes the current round of inflationary pressure unique is that both tariffs and rising oil prices are supply-side shocks, directly pushing up input costs for production, while the Fed's interest rate tools mainly work on the demand side—stimulating or restraining spending by businesses and consumers. Their effectiveness in cooling supply-side shocks is very limited.

Brian Bethune stated bluntly, "In this situation, the Fed simply cannot cut rates." He said the crux of the issue is that the Fed cannot easily "slam the brakes" on inflation.

Anderson further warned that if the conflict turns into a protracted war, it's possible that the Fed's next move will be a rate hike, not a cut.

Analysts: High probability of U.S. military action against Iran

Many geopolitical and macroeconomic analysts believe the probability of the U.S. taking military action against Iran is rising, which will be the key variable affecting oil prices.

Suzanne Maloney, director of the Foreign Policy program at Brookings, pointed out that since January, the U.S. has been "increasing its military presence in the Middle East gradually." Christopher Granville, Managing Director at TS Lombard, said that the probability of U.S. military action against Iran "appears to be greater than 50%."

Granville believes that even if a military confrontation occurs, the likelihood of a full-blown oil crisis and stagflation shock for the global economy remains limited. However, we cannot rule out a scenario similar to the "oil price spike" after the Russia-Ukraine war began in early 2022—when oil prices soared above $100 a barrel and stayed high for about six months. That round of shocks was enough to push U.S. inflation much higher, with the core PCE price index rising to an annual rate of 5.6% in September 2022, the highest in nearly 40 years.

Currently, most bank analysts still forecast that the average oil price in 2026 will remain slightly above $60 per barrel, but acknowledge the Middle East outlook is highly unpredictable.

Iran's retaliation capability is a key uncertainty

The potential impact of Iran on oil prices will rely not just on any U.S. military action itself, but also on Iran's potential retaliation strategies.

Karen Young, Senior Research Scholar at Columbia University's Center on Global Energy Policy, noted that the key to how high oil prices could spike lies in whether Iran responds to U.S. actions by attacking oil production facilities in nearby countries.

In addition, Iran has the ability to disrupt shipping through the Strait of Hormuz. The Strait of Hormuz is a key shipping channel connecting the Persian Gulf, the Gulf of Oman, and the Arabian Sea through which a large volume of global oil is transported.

Vali Nasr, Professor at Johns Hopkins University’s School of Advanced International Studies, believes Iran is likely to target its neighbors. At a discussion this week hosted by the Chicago Council on Global Affairs, he said the Iranian government’s calculus is that if Trump believes war comes at no cost, "he will keep doing it," so Tehran has an incentive to respond strongly.

HSBC also forecast in its latest report that even if Iran temporarily blocks the Strait of Hormuz, Brent crude oil would quickly surge to $80 per barrel (currently $73).

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