As oil goes, so goes inflation?
Much depends on how long the Strait of Hormuz is blocked during the Iran conflict.
Bottom Line
The US military’s Operation Epic Fury is approaching one-month and financial markets have responded poorly. The S&P 500 is down 9% from its record intraday high of 7,002 in late January and March is on track to post its worst monthly performance since 2022. Benchmark 10-year Treasury yields, which typically enjoy a flight-to-safety rally amid a sharp equity market sell-off, have been more focused on a potential spike in inflation, with yields soaring from 3.95% at the end of February to 4.41% today. The volatility index (VIX) temporarily spiked from 20 at the end of February to 35 on March 9; it “settled” at 31 today.
Crude oil prices soar The US and Israel launched joint attacks on Iran on February 28 to degrade its ability to use nuclear weapons, destroying much of its naval, air force and communications capabilities in the process. But the Strait of Hormuz remains effectively closed, due to Iran’s strategic use of naval mines, missile drones, and small attack boats.
The Strait is a critical chokepoint through which 20% of the world’s oil flows. The shutdown caused crude prices (West Texas Intermediate) to spike 54% over the past month, from $65 per barrel at the end of February to $100 today. Lagging gasoline prices have risen 33% over the same period, from $2.98 per gallon at the end of February to a four-year high of $3.98 today. President Trump has guaranteed the safe passage of tankers via a naval escort, insured by the US International Development Finance Corp. But Iran has effectively used its geographic and tactical advantages in the region to deter ships. It is demanding a $2 million toll for safe passage of each tanker, a ransom the US and its allies have no interest in paying.
Uncertainty extended The Trump administration had set a four to six week timeline to conclude this conflict. Consequently, we expected that the military was preparing for a so-called “final blow” this week to regain critical control of the Strait of Hormuz, allow the free passage of ships daily and lower energy prices. But yesterday, Trump gave Iran an additional 10 days to allow negotiations to bear fruit, extending the deadline to April 6.
Dueling peace plans President Trump also announced a 15-point peace proposal earlier this week. It demands that Iran never pursue nuclear weapons, dismantle its three main nuclear facilities and surrender all enriched uranium to the International Atomic Energy Agency. The country would also have to suspend its ballistic missile production, open the Strait of Hormuz and cease to fund its regional proxies Hamas, Hezbollah and the Houthis. Not surprisingly, Iran rejected the plan. In turn, it demanded war reparations, recognition of its sovereignty over the Strait, an end to international sanctions and protections for its proxy groups. It seems inevitable that the military conflict will continue into April. President Trump has rescheduled his summit in China with President Xi to May 15-16.
Impact on inflation Core CPI, which strips out volatile energy and food costs, has moderated from a 40-year high of 6.6% y/y in 2022 to a nearly five-year low of 2.5% in February 2026. Nominal CPI has followed a similar path to 2.4% in February 2026. But crude oil prices have spiked 82% since their five-year low of $55 per barrel in mid-December to a four-year high of $100 today. Lagging gasoline prices have soared by 43% from a five-year low of $2.80 per gallon in mid-January to a four-year high of $3.98 today. To be sure, investors and the Federal Reserve are expecting at least a temporary inflationary increase in coming months due to this war-related spike in oil prices. Goldman Sachs reports that every $25 increase in crude oil prices raises core PCE inflation by 0.1%. The core PCE (the Fed’s preferred measure of inflation) bottomed out at a four-year low of 2.6% in April 2025, but it has already risen to 3.1% in January 2026, before the surge in oil prices.
Some bearish forecasts are expecting crude to slice through the $130 high during the early days of the Russia/Ukraine war in 2022, moving up to $150-200 per barrel over the next year and beyond. But optimistic estimates expect a much shorter military conflict, in which costs could recede to $65 in coming months. The US is the world’s largest oil producer at 13.7 million barrels per day, and OPEC will collectively add 206,000 barrels per day starting in April. The US Strategic Petroleum Reserve is about 58% full at 415 million barrels.
Could the Fed’s next move be a hike? The military conflict with Iran, the spike in oil prices and the possible impact on inflation complicate our expectations for additional interest rate cuts this year. True, with the upper band of the fed funds rate at 3.75% and nominal CPI inflation at 2.4%, the Fed has plenty of room to reduce rates to a terminal value of 3.0%. But the yield on two-year Treasuries — which many equate to the fed funds rate — soared from 3.38% at the end of February to 3.99% yesterday. Instead of a quarter-point cut, could the Fed’s next move be a hike to combat energy-related inflationary pressures?
Consumers souring This morning’s University of Michigan Consumer Sentiment Index declined from a six-month high of 56.6 in February to 53.3 in March. The Conference Board’s Consumer Confidence Index is expected to slip from 91.2 in February to an estimated 88.0 in March. In conjunction with much higher energy prices, at least temporarily, these declines in sentiment likely will contribute to slower economic growth. The Atlanta Fed’s GDPNow tracking estimate for the first quarter of 2026 has fallen from 3.0% in early March to 2.0% this week.
Read more about our views and positioning at Capital Markets.