The tension in Iran is driving up oil prices, and the "space for the Federal Reserve to cut interest rates this year is disappearing."

The combination of rising oil prices and tariff pressures is sharply narrowing the space for the Federal Reserve's monetary policy maneuvering. Several economists have warned that if the U.S. takes military action against Iran, the inflation situation will further deteriorate, and the possibility of the Federal Reserve cutting interest rates this year may be completely dashed.

As tensions between the U.S. and Iran escalate, WTI crude oil futures have risen about 16% this year, with prices per barrel increasing by approximately $10 since the beginning of the year. Brian Bethune, an economist at Boston College, stated in a media interview, "The reasons supporting a rate cut are disappearing before our eyes." He pointed out that the rise in oil prices, combined with the Trump administration's aggressive tariff policies, is creating upward pressure on inflation, making the decision to cut rates increasingly complex.

Traders in the derivatives market still expect the Federal Reserve to cut rates twice this year, each by 25 basis points, with the first cut anticipated in June and the second in September. However, several analysts believe that the evolution of geopolitical risks may make this expectation difficult to fulfill. Scott Anderson, Chief U.S. Economist at BMO Capital Markets, warned that if the conflict persists, the Federal Reserve may even consider raising rates next.

Inflation Pressure Rising Before Rate Cuts

Before the situation with Iran escalated, U.S. inflation data had already shown signs of a troublesome rebound for the Federal Reserve.

Wholesale prices began to accelerate in December last year and are currently rising at an annual rate of 3%. Ethan Harris, former Chief Economist at Bank of America Securities, noted in a research report published on LinkedIn that the rise in producer prices is likely to soon be transmitted to the consumer level.

Anderson indicated that inflation appears to be heating up in the first quarter of this year. The core Personal Consumption Expenditures (PCE) price index may rise to an annual rate of 3.1% in January, the highest level in nearly two years—this data was collected before any potential U.S. military action against Iran. The Federal Reserve's inflation target is 2%.

He estimates that for every $10 increase in oil prices, consumer price inflation will rise by 0.2 to 0.4 percentage points within the next year. Given that oil prices have already risen by about $10 this year, the impact should not be underestimated.

"The mere increase in the risk of conflict with Iran is already impacting the energy market and prices, exacerbating inflation pressures in the U.S. and creating significant resistance for the Federal Reserve to further cut rates," Anderson said.

Tariffs and Oil Prices as Supply-Side Shocks, Monetary Policy Hard to Address

Economists point out that the uniqueness of this round of inflation pressure lies in the fact that both tariffs and rising oil prices are supply-side shocks that directly raise production input costs, while the Federal Reserve's interest rate tools primarily affect the demand side, adjusting the economy by stimulating or suppressing spending by businesses and consumers, with very limited effects on cooling supply-side shocks.

Brian Bethune bluntly stated, "In this situation, the Federal Reserve simply cannot cut rates." He indicated that the core issue is that the Federal Reserve finds it difficult to "hit the brakes" on inflation.

Anderson further warned that if the conflict evolves into a prolonged war, it is possible that the Federal Reserve's next action will be to raise rates rather than cut them

Analysts: Higher Likelihood of Military Action Against Iran

Several geopolitical and macroeconomic analysts believe that the probability of the United States taking military action against Iran is rising, which will be a key variable affecting oil price trends.

Suzanne Maloney, director of the Foreign Policy Program at the Brookings Institution, pointed out that since January of this year, the U.S. has been "gradually and slowly" increasing its military presence in the Middle East. Christopher Granville, managing director of TS Lombard macro forecasting consultancy, stated that the "likelihood of U.S. military action against Iran seems to exceed 50%."

Granville believes that even if military confrontation occurs, the possibility of a global economic downturn leading to a full-blown oil crisis and stagflation remains limited. However, he does not rule out a scenario similar to the "surge in oil prices" following the outbreak of the Russia-Ukraine war in early 2022—when oil prices briefly surpassed $100 per barrel and remained high for about six months. That round of shocks was sufficient to drive U.S. inflation significantly higher, with the core PCE price index rising to an annual rate of 5.6% in September 2022, the highest level in nearly 40 years.

Currently, most bank analysts still predict that the average oil price will remain in the low range of just over $60 per barrel by 2026, but they also admit that the trajectory of the situation in the Middle East is difficult to predict.

Iran's Counteraction Capability is a Key Uncertainty

The potential impact of Iran on oil prices depends not only on U.S. military actions themselves but also on the possible counteractions from Iran.

Karen Young, a senior research scholar at Columbia University's Center on Global Energy Policy, pointed out that the key to the magnitude of the oil price surge lies in whether Iran will strike oil production facilities in neighboring countries in response to U.S. actions.

Additionally, Iran has the capability to disrupt shipping in the Strait of Hormuz. The Strait of Hormuz is a vital shipping route connecting the Persian Gulf, Gulf of Oman, and the Arabian Sea, through which a significant amount of the world's oil is transported.

Vali Nasr, a professor at the Johns Hopkins School of Advanced International Studies, believes that Iran is likely to choose to strike its neighbors. He stated at a discussion hosted by the Chicago Council on Global Affairs this week that the Iranian government's judgment is that if Trump believes there are no costs to war, "he will continue to do so," thus Tehran has the motivation to respond strongly.

HSBC's latest research report also predicts that even if Iran briefly blocks the Strait of Hormuz, Brent crude oil will quickly surge to $80 (currently $73)