Three wars, three economies
Since the start of Operation Epic Fury, we’ve focused on a crucial question: Economic impact of the Iran war How long will it continue? The Strait of Hormuz stands as a dividing line between fear and shock, with the level of shock depending largely on duration. Wall Street is currently evaluating this situation, and their estimates are worth noting.
A research team from Bank of America put together some interesting findings. 3 different economic scenarios They challenge the common market belief that oil price spikes lead to inflation, prompting the Federal Reserve to tighten policies. This assumption is incorrect in at least two out of three situations, and it could create significant issues if the Fed takes it too seriously.
short war
If the conflict is resolved quickly — Hormuz Island reopens Global oil supplies could bounce back to pre-war levels, minimizing damage. Bank of America predicts a PCE inflation rise of about 15 basis points and a growth decrease of around 15 basis points over the year, which are quite minor adjustments. They also forecast that Brent crude oil prices may average about $70 per barrel by 2026. In this scenario, the Fed would likely adopt a wait-and-see approach. For most Americans, the only noticeable impact would probably be the temporary pain at the pump they are already feeling.
middle war
If the conflict extends into spring, the dynamics will shift. Bank of America forecasts growth to be between 2% and 2.5% in 2026, down from a previous expectation of 2.8%, with year-end headline and core PCE inflation expected around 3% and average oil prices near $85.
Inflation will certainly be felt, and it’s essential to understand the causes. Energy costs will surge, affecting gas and utility bills. The situation in Hormuz has disrupted approximately 20% of global LNG supplies. Rising pressure on natural gas This, in turn, will likely increase electricity costs throughout Europe and Asia. Plus, the consequences for fertilizers may be underestimated. Gulf countries make up a significant share of global urea and ammonia exports, primarily routed through Hormuz. This isn’t a simple matter of passing higher costs onto farmers. More likely, we’ll see supply shortages, impacting grain yields when crops in the Northern Hemisphere come in six to twelve months from now.
This scenario is particularly challenging for the Fed, leaving it in a precarious situation. Inflation will be uncomfortably high, but growth will be moderate rather than collapsing. Clean movements in policy don’t really happen. Bank of America expects the Fed to remain inactive unless unemployment trends up toward 5%. However, as we noted at the start of this conflict, the Fed’s credibility could be at stake due to the temporary inflation problem, creating a difficult choice: Show toughness by being hawkish When gas prices soar and inflation headlines are overwhelming, it’s often easier to react strongly than to calmly explain why a measured response is more appropriate.
This concern is compounded by several factors. One is Fed hostility toward President Trump and his administration. In 2019, William Dudley, former president of the New York Fed, suggested that the Fed should avoid enabling Trump’s tariff policies, implying that tolerating short-term economic damage might serve a greater purpose. Even if many current Fed officials don’t openly support this line of thinking, it probably influences their decisions. Why would they back “Trump’s war” on Iran? Allowing some immediate damage might further weaken Republicans’ midterm prospects and limit Trump’s policy effectiveness.
This would represent a significant policy error. The Fed’s aggressive stance could, in fact, lead to a recession. Just because an action appears unwise doesn’t mean the Fed won’t opt for it.
long war
In a drawn-out conflict scenario, conventional wisdom may fall apart. If the fighting continues into the latter part of the year, stagflation is unlikely. Even a recession—regardless of the Fed’s decisions—could lead to serious issues. Recession is deflation.
The reasoning is straightforward. When oil prices exceed $100, demand diminishes. Higher-income consumers can reduce spending, while low-income consumers are already feeling budgetary strain, facing rising overdue bills and tighter access to credit. Bank of America estimates that this outlook could lower GDP growth to about 1%, with a worse case leading to a full contraction. At that point, energy and food price inflation might only be temporary, but dwindling demand would be a lasting concern. Historical data shows that when oil prices drop significantly, the Fed typically cuts interest rates significantly in response.
Hidden risks in all three
However, Bank of America’s scenario analysis doesn’t fully address risks that could exist across all three outcomes. Back when Ben Bernanke was still a professor, he co-authored research suggesting that many historical “oil shock recessions” may have stemmed from policy reactions rather than the oil shocks themselves. The Federal Reserve can tighten its policies excessively as prices fluctuate. Pushing the economy into a recession that wasn’t solely caused by the oil shock.
Right now, the conditions could allow for short-term spikes. The five-year/five-year breakeven inflation rate is near its historical low, giving the Fed room to be patient. Iranian missile attacks and rising oil prices alone won’t significantly strain the U.S. economy.
But mistakes in monetary policy could shorten this period. The distance between fear and shock poses a risk in every potential scenario.
