Fed Faces 5% Inflation Risk as Oil Prices Surge to $130

The Federal Reserve is poised to raise interest rates as inflation risks escalate, driven by surging oil prices. The recent military conflict in the Middle East has triggered a significant increase in oil prices, putting pressure on the Fed to act.

The US conducted airstrikes on three nuclear sites in Iran last Saturday night, following Iran's response to earlier Israeli attacks. In retaliation, Iran has shut down the Strait of Hormuz, a critical global oil route. This closure has the potential to disrupt a significant portion of the world's oil supply, with analysts predicting that oil prices could surge to $130 per barrel. Such a spike would push US inflation back to 5%, the same level seen in March 2023 when the Fed was aggressively raising rates.

Historical research reviewed by the Fed in 2010 indicates that persistent oil shocks lead to weaker consumption and investment, along with a depreciation of the dollar. Countries that import oil, like the United States, experience a decline in national wealth as oil prices rise. This loss in wealth results in reduced spending, a weaker exchange rate, and shifts in trade balances. While efforts to cut down on oil use may be made, they are often insufficient to mitigate the economic damage. The outcome is a worsened oil trade balance and decreased imports of other goods, although the non-oil part of the trade balance may improve due to an overall economic slowdown.

Tensions in the Middle East have escalated following unprovoked airstrikes by Israel on Iranian territory, to which Iran responded with retaliatory actions. Over the weekend, the US joined the conflict by bombing three nuclear facilities in Iran. In response, Iran's foreign minister stated that the country reserves the right to defend its sovereignty. Iran has previously threatened to close the Strait of Hormuz, a narrow waterway that carries one-fifth of the world's oil daily and sees more traffic than both the Panama and Suez Canals. About 35% of all seaborne LNG also passes through it. The US Navy has maintained a presence in the area for decades due to its strategic importance.

If Iran follows through on its threat to close the Strait of Hormuz, energy prices are expected to skyrocket. The Strait is the only sea route out of the Persian Gulf, and its closure would cut off access to a substantial portion of the global oil supply. This scenario would likely provoke a military response from the US and Israel. The US Secretary of State has called on China to intervene and persuade Iran to back down, given China's significant dependence on oil from the Strait of Hormuz and its friendly diplomatic ties with Tehran.

Amid rising global tensions, President Donald Trump has continued to advocate for interest rate cuts, even before his potential reelection in 2024. Trump has been publicly critical of Fed Chair Jerome Powell, demanding cheaper borrowing costs. However, with oil prices potentially reaching $130 and inflation rising toward 5%, rate cuts are not feasible. Instead, the Federal Reserve is likely to raise rates again, similar to the actions taken in 2023. The link between oil prices and inflation is well-established, and the Fed's own research shows the damaging effects of oil shocks, especially when financial markets struggle to absorb the risk. The more severe the shock, the more challenging it becomes to combat the resulting high inflation.

With Trump pushing for rate cuts and Powell facing pressure from rising costs, the Federal Reserve is once again navigating both political and economic challenges. The potential for oil prices to surge to $130 per barrel, driven by the closure of the Strait of Hormuz, poses a significant risk to the US economy. The Fed's historical research underscores the detrimental effects of oil shocks on consumption, investment, and national wealth, making it crucial for the central bank to act decisively to mitigate these risks.