As the conflict between Iran and Israel continues to escalate, its potential impact on the US economy and the Federal Reserve’s interest rate decisions has become a closely watched topic among investors. The conflict has already spread to the energy market, with oil prices surging and concerns about broader geopolitical disruptions.
Market Expectations: Delayed Rate Cuts vs. Accelerated Rate Cuts
Initially, the general market view was that the Iran-Israel conflict would delay the Federal Reserve’s interest rate cut schedule. This is because the conflict could stimulate a rise in oil prices, pushing up inflation risks. However, some economists argue that the ongoing conflict might prompt the Federal Reserve to cut interest rates earlier than expected. The reasoning is that the risk of recession brought about by the conflict is greater than the risk of inflation.
Analysis: The Potential for a More Dovish Stance
Ryan Sweet, Chief US Economist at Oxford Economics, recently wrote in a report to clients that the continuous rise in oil prices may lead the Federal Reserve to adopt a more dovish stance. Sweet believes that the ongoing oil shock could weaken demand and potentially spill over into the labor market, which has been robust until now.
Historically, sudden spikes in oil prices have often led to only temporary increases in inflation, which the Federal Reserve typically overlooks. However, given that the US economy is already showing signs of weakness, a persistent surge in oil prices could pose a greater threat to economic growth and employment than to inflation itself.
Sweet noted, “The economy has slowed and is vulnerable to anything else going wrong, including a sudden and persistent increase in oil prices.” If the Federal Reserve views the impact on the economy and the labor market as greater than the temporary boost to inflation, the central bank could signal its willingness to cut interest rates sooner.
Current Oil Price Trends and Future Outlook
On Monday, international oil prices temporarily stabilized around $70 per barrel, following last Friday’s significant increase. Sweet pointed out that it might take the market several weeks to gain a clearer understanding of the trend in oil prices. His baseline forecast is that the Federal Reserve will deliver its first rate cut in December. However, he noted that a significant and sustained increase in oil prices could bring forward the rate cut by one meeting.
Risks and Uncertainties
Wall Street analysts have warned that if the conflict persists and potentially leads to the closure of the Strait of Hormuz, oil prices could surge to $130 per barrel, pushing the US inflation rate to 6%. This scenario would complicate the Federal Reserve’s decision-making process, as higher inflation could delay rate cuts even further.
Jon Faust, a former senior advisor to Federal Reserve Chair Jerome Powell, recently stated that the ongoing conflict in the Middle East is a “major wild card” for the Federal Reserve. He believes that while a rate cut in December is possible, the odds are “50/50,” as the Federal Reserve will only act when the data supports it.
Conclusion: A Balancing Act for the Federal Reserve
The Federal Reserve will hold a meeting on June 17th-18th to discuss interest rate policies. The market widely expects that the central bank will keep interest rates unchanged for the fourth consecutive time. However, the ongoing Iran-Israel conflict introduces significant uncertainty into the equation. While some economists argue that the risk of recession could prompt earlier rate cuts, others warn that higher oil prices and inflation could delay them.
Ultimately, the Federal Reserve will need to balance the risks of recession and inflation, taking into account the evolving geopolitical situation and its impact on the US economy.
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