By: Tom Pawlicki, Senior Specialist, Market Intelligence
There is guesswork on the long-term path of oil prices after an eventual end to the Iran war, and whether they will quickly fall back to pre-war levels. Similar guesswork is taking place with interest rates in light of the five-week advance in the 10-year of 0.50%, and the elimination of projected rate cuts in light of the prospects for oil-driven inflation.
WTI crude oil retraced more than 50% of its Iran war rally in yesterday’s trade based on the announcement of a two-week ceasefire. The ceasefire agreement is tenuous and oil prices are trading higher again today. The longer-term view in oil is important for inflation, as the damage that has been done to energy production, pipeline, refinery and shipping infrastructure in the Middle East suggests that prices will not quickly fall back to their pre-war levels. That could prevent oil prices from quickly falling back to pre-war levels around $65 in WTI and $70 in Brent.
QatarEnergy said it would take 3-5 years to repair and restart the 17% of capacity that was damaged in an Iranian missile strike. Kuwait Petroleum said that when the war ends, it would be able to restore full output in three to four months. Many oil wells and refineries in the Middle East will need several weeks or even months to get back up to full speed. That suggests that the interest rate and energy markets are likely to be more intertwined over the next 6-12 months as a slow pullback in energy prices could lead to an equally slow reduction in interest rates.
The FOMC minutes published yesterday afternoon not surprisingly confirmed the trend toward caution with regard to further cuts in interest rates. The FOMC meeting on March 18 updated the SEP and showed a consensus for one rate cut by year-end. While that was unchanged from the previous meeting, the number of Fed participants expecting more than one cut this year fell from eight to five and represented a small hawkish shift. In the press conference after the meeting, Fed Chairman Powell acknowledged that inflation has been above the Fed’s target for five years, and said that if there is not progress on inflation by mid-year due to favorable tariff comparisons, there won’t be any more rate cuts.
The FOMC minutes added to the hawkish slant by changing wording on member views compared to the prior meeting’s minutes. For the January meeting, the minutes said that “several” participants cautioned that easing policy further in the context of elevated inflation readings could be misinterpreted as accepting high inflation. For the March meeting, the minutes said that “many participants” pointed to the risk of inflation remaining elevated for longer than expected amid a persistent increase in oil prices. It noted that the resulting elevated inflation could call for rate increases. The odds of rate cuts were falling somewhat before the war began, but have dropped considerably since. Jay Powell has one more meeting as chairman on April 29, but may stay on as chairman pro-tem if his successor is not confirmed by his expiration as chairman on May 15. The odds of a cut at the successor’s first meeting on June 17 are currently at 0%, while odds of one cut by the last meeting of this year are at 22%.
Today’s PCE price data once again affirmed the slow pace that inflation is unwinding after the surge several years ago. PCE was unchanged +2.8% y/y in February but up from +2.3% in April 2025. Core PCE fell to +3.0% y/y from +3.1%, but remains above the +2.6% reading from April 2025. The Fed has interpreted that roughly 0.5% increase as tariff-related and has not seen prices fall back to those levels yet. Now it has to anticipate the inflationary effects from the Iran war, which will push back expectations of rate cuts even further.
PCE and CPI both fell after the Iraqi invasion of Kuwait in 1990 in spite of the spike in oil prices, although the economy was near a recession at the time. Following the Russian invasion of Ukraine in early 2022, PCE fell for five months before rising again while CPI increased another 1 1/2% within four months. With the current economy still somewhat strong, an increase of 1.0% or 1.5% in inflation would put CPI and PCE around 3.5%-4.0% and very close to the current Fed Funds rate of 3.50%-3.75%. A short war with Iran would make such a surge in inflation unlikely, but if the war lasts several months or if there are inflationary implications such as Hormuz tolls, such a surge would be possible. That could set up a shock to the economy which could enter a recession and trap the Fed into choosing between raising rates due to the risk of higher inflation or cutting rates to prevent a recession.
The stagflationary trends will make the job for a new Fed chairman more difficult, as he will have to convince other members besides Stephen Miran to support rate cuts during a continued elevated period of inflation.
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