Recession Risks Outweigh Inflation? Economists Expect Iran-Israel Conflict May Prompt the US Fed to Accelerate Interest Rate Cuts

As the war between Iran and Israel continues to escalate, one of the topics closely watched by investors is how the US economy will be affected and how it will influence the US Fed's interest rate path.

Currently, the conflict between Iran and Israel has spilled over into the energy market. The prevailing view in the market is that the Iran-Israel conflict will delay the US Fed's timetable for an interest rate cut, as it will stimulate oil price increases and heighten inflation risks.

However,there is also a view that the ongoing war between Iran and Israel might prompt the US Fed to cut interest rates earlier than expected, as the recession risks it brings are greater than inflation risks.

Ryan Sweet, Chief US Economist at Oxford Economics, wrote in a recent report to clients: "Sustained oil price increases could lead the US Fed to adopt a more dovish stance." He believes that a sustained oil shock could weaken demand and potentially spill over into the otherwise resilient labour market.

This is because, historically, sudden spikes in oil prices have often only led to temporary increases in inflation, which the US Fed typically ignores. However, given the already weakened economy, the threat of sustained oil price spikes to economic growth and employment may outweigh inflation itself.

"The economy has already slowed down and is vulnerable to any other factors, including sudden and sustained oil price increases," Sweet said. "If the US Fed believes that the impact of oil prices on the economy and labour market outweighs the temporary push to inflation, then the central bank may signal a willingness to cut interest rates earlier."

On Monday, international oil prices paused their upward trend, stabilizing at around $70 per barrel. On Friday, oil prices recorded their largest gain in three years.

However, Sweet pointed out that the market may need several weeks to gain a clearer understanding of oil price movements. His base forecast isthat the US Fed will make its first interest rate cut in December.

Sweet noted that although the US Fed has enough patience, given the damage that sustained and significant oil price increases could cause to the economy,the timing of the US Fed's interest rate cut might occur "one meeting earlier" than planned.

"This could be a hot topic at future Federal Open Market Committee (FOMC) meetings, but it won't be at next week's (referring to Wednesday to Thursday this week) meeting," Sweet added.

In other words, Sweet believes that the Iran-Israel conflict may slightly advance the US Fed's timetable for an interest rate cut. Overall, his view aligns with other Wall Street figures, who firmly believe that the US Fed will maintain a wait-and-see stance in the foreseeable future.

The US Fed will hold a meeting on June 17-18 to formulate interest rate policies. The market widely expects the central bank to keep interest rates unchanged for the fourth consecutive time. Since December last year, the US Fed has maintained the benchmark interest rate within the range of 4.25% to 4.5%.

Wall Street analysts have warned that if the conflict persists and the Strait of Hormuz is potentially closed, it could push oil prices up to $130 per barrel and the US inflation rate up to 6%.

Some economists had previously warned that a sharp surge in inflation could delay the Fed's first interest rate cut until early 2026.

Jon Faust, a former senior advisor to Fed Chairman Powell, recently stated that while it is too early to determine how the Israel-Iran conflict will unfold, the situation in the Middle East is a "significant uncertainty" for the Fed and could trigger a US recession.

Stephen Juneau, a senior US economist at Bank of America, told the media on Monday that a more severe scenario of "stagflation" could emerge. However, he also pointed out that compared to a year ago, oil prices are still relatively low, "so we need to see how things develop next. I think it's too early to draw conclusions now."