The Dual Threat of a Fed Rate Cut Acceleration in a Prolonged Israel-Iran Conflict

The ongoing conflict between Israel and Iran has the potential to have far-reaching consequences beyond just disrupting energy markets. One argument on Wall Street is that it could push the Federal Reserve to cut interest rates sooner than expected. According to Ryan Sweet, the chief US economist at Oxford Economics, a sustained rise in oil prices could cause the Fed to adopt a more dovish tone. He argues that an extended oil shock could dent demand and potentially spill over into an otherwise resilient labor market. Historically, sudden spikes in oil prices tend to cause only a temporary rise in inflation that the Fed usually overlooks. However, with the economy already showing signs of softening, a persistent surge in oil prices could pose a bigger threat to growth and jobs than to inflation itself. "The economy has slowed and is vulnerable to anything else going wrong, including a sudden and persistent increase in oil prices," Sweet said. "If the Fed views the hit to the economy and the labor market as greater than the temporary boost to inflation, the central bank could signal that it's open to cutting interest rates sooner." On Tuesday, oil prices rallied, with international benchmark Brent (BZ=F) rising above $75 a barrel after President Trump called for Tehran residents to evacuate and rebuffed the idea of an Israel-Iran ceasefire. West Texas Intermediate (CL=F) crude hovered around $74. This contrasted with optimism on Monday, when the Wall Street Journal reported that tensions between Iran and Israel had eased, sparking a rally in US equities and stabilizing crude oil prices following last week's biggest price surge in three years. Sweet, whose baseline forecast is that the Fed will deliver its first rate cut in December, noted it may take weeks before markets gain a clearer sense of the direction of oil prices. While the Fed can afford to be patient, Sweet said a significant and sustained increase in oil prices could bring forward the rate cut by a meeting because of the damage it will do to the economy, which is harder to fix than waiting out the temporary acceleration in headline inflation. However, there is also the other side of the coin: the inflationary impact. Wall Street analysts have warned that a prolonged conflict and the potential closure of the critical Strait of Hormuz could drive oil prices as high as $130 a barrel, pushing US inflation back toward 6%. This would likely lead to higher gas prices, which have been a key factor in the disinflationary trend over the past several months. According to the latest May CPI report, gas prices have fallen 12% over the past year. The government's energy index declined 1% month over month in the most recent reading. If those trends reverse, economists warn that a sharp inflation surge could delay rate cuts until early 2026 as the central bank balances its dual mandate of price stability and maximum employment. While the Fed tends to focus on inflation metrics that exclude volatile categories like energy, there is concern that higher energy costs could cause ripple effects through the supply chain and result in price increases for other goods and services.