One way a prolonged Israel-Iran conflict could accelerate Fed rate cuts

Link copied

One way a prolonged Israel-Iran conflict could accelerate Fed rate cuts.

watchlist :: 9hrs ago :: source - yahoo finance

By Allie Canal

Federal Reserve Chair Jerome Powell speaks during the Thomas Laubach Research Conference at the William McChesney Martin Jr. Federal Reserve Board Building in Washington, D.C., on May 15. (Jim Watson/AFP via Getty Images)

A prolonged conflict between Israel and Iran may do more than rattle energy markets. One argument on Wall Street is that it could push the Federal Reserve to cut interest rates sooner than expected.

"A sustained rise in oil prices could cause the Fed to strike a more dovish tone," Oxford Economics chief US economist Ryan Sweet wrote in a recent note to clients, arguing that an extended oil shock could dent demand and potentially spill over into an otherwise resilient labor market.

That's because historically, sudden spikes in oil prices tend to cause only a temporary rise in inflation that the Fed usually overlooks. But with the economy already softening, a persistent surge 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 to about $74 a barrel after President Trump called for Tehran residents to evacuate and rebuffed the idea of an Israel-Iran ceasefire.

That 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."

"This is a potential hot topic at a future Federal Open Market Committee meeting, but not next week's," Sweet added, echoing others on Wall Street who firmly believe the Fed will remain on pause for the foreseeable future.

That said, the inflationary impact is the other side of the coin.

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's concern that higher energy costs could cause ripple effects through the supply chain and result in price increases for other goods and services.

"You're looking at a potentially more 'stagflationary' scenario out of that," Bank of America senior US economist Stephen Juneau told Yahoo Finance on Monday. "Of course, this has to persist. We're still at a point where oil prices are relatively low compared to a year ago, so we'll just have to see how things unfold from here. I think it's too early to say."

Allie Canal is a Senior Reporter at Yahoo Finance. Follow her on X @allie_canal, LinkedIn, and email her at alexandra.canal@yahoofinance.com.