War in Middle East expected to boost inflation, could delay Fed rate-cut plans

The war in the Middle East is driving up inflation expectations and is expected to push the pace of rising prices further away from the US Federal Reserve's policy target, potentially delaying plans to cut interest rates further.

US and Israeli military operations against Iran have driven up oil and gas prices, triggered fresh volatility in stocks and bonds and injected a new bout of uncertainty into the global economy. The most immediate impact for US consumers will be gasoline prices, which were already rising as stations switched to the more expensive summer blends. Surging prices at the pumps will have sweeping impacts across the domestic economy.

"This could raise inflation expectations more than actual inflation itself," Derek Tang, an economist with Monetary Policy Analytics, said in an interview. "That would add insult to injury to household budgets after the high inflation of recent years and tariff risks still passing through. Psychologically, consumer sentiment has been poorer than actual economic activity in part because of the price level shock."

The five-year breakeven inflation rate rose to 2.46% on March 2, up 20 basis points from the end of 2025. The 10-year breakeven rate stood at 2.29%, nearly unchanged from 2025-end.

"Inflation expectations are still stable," Joseph Wang, a former senior trader on the Fed's Open Markets Desk and the operator of financial markets research blog Fedguy.com, told S&P Global Market Intelligence. "However, that could change should the high prices persist due to, say, structural damage in Middle East oil facilities."

How much this conflict impacts prices, consumer sentiment and global central bank policies will depend on the severity and length of the conflict, according to Jane Foley, head of foreign exchange strategy with Rabobank.

"Clearly it will be the duration of the conflict and the nature of specific events related to the supply of oil and gas that will determine how far inflation expectations are likely to be thrown off course," Foley said in an interview.

If higher oil prices hold and if gasoline prices rise to a nationwide average of $3.50 per gallon, about 40 cents per gallon higher than they were March 3, according to the American Automobile Association, headline inflation could rise about 60 basis points, said James Knightley, chief international economist at ING.

With higher energy prices also raising airline fares and other transport and logistic costs, this would put annual growth of the consumer price index, the market's preferred measure of inflation, above 3% for the first time since May 2024, Knightley told Market Intelligence. If tensions escalate further and a prolonged war and heavily disrupted global oil supply pushes oil prices up to $90 per barrel and gasoline near $4 per gallon, there would be far more of a squeeze on household spending power.

The Fed will likely be wary of cutting rates if inflation continues to rise beyond 3%. However, if the potential decline in consumption leads to a loss of American jobs, the Fed may move quickly to cut its benchmark federal funds rates.

"The US' dual mandate means it needs to optimize for two very different goals of price stability and maximum employment," Knightley said. "A prolonged energy spike would cause near-term inflation, but the Fed may take the view that it will also be demand destructive, which would dampen inflation over the medium to longer term, which would justify eventual rate cuts."

A sustained 10% rise in oil prices would add about 30 bps to the year-over-year consumer price index in the second and third quarters of this year, according to a March 2 analysis by Wells Fargo economists. A 30% jump would increase the index by 100 bps, or a full percentage point, pushing the market's inflation gauge to levels not seen since mid-2024.

A March 2 analysis by economists at Goldman Sachs estimated that a sustained 10% increase in oil prices would boost the consumer price index by 28 bps. Meanwhile, the core consumer price index, which removes volatile energy and food prices, would rise just 4 bps.

However, if the increase in oil prices is more persistent, annual consumer price index growth is projected to reach 3% in May and remain above that level throughout 2026, a full percentage point higher than the Fed's inflation target.

As of March 3, about 60% of the futures market was expecting at least two 25 bps cuts from the Fed by the end of 2026, roughly the same as a month ago, according to CME FedWatch.

The economic impact of this latest conflict in the Middle East will likely not be uniform, impacting sectors and parts of the US and world differently, said Tang with Monetary Policy Analytics.

"As such, Fed officials could be minded to hold off on any more cuts until the coast is clear," Tang said.