Is the inflation scare over? Iran cease-fire leads to hope for more Fed interest-rate cuts.

By Jeffry Bartash

U.S. economy could rev up if the war really is over

Gasoline prices are high, as evidenced by this Shell gas station in West Hollywood, Calif., but could begin to fall soon if the conflict with Iran really is over.

Inflation is going to get worse before it gets better, but price increases tied to the Iran war could start to evaporate during the summer and allow the Federal Reserve to cut interest rates again to aid the economy.

That's the view of a majority of Wall Street economists six weeks after the U.S. conflict with Iran began. A mood of high anxiety a few weeks ago has given way to cautious optimism amid a fragile cease-fire and retreating oil prices.

"You can never be certain," said Dave Donabedian, senior investment strategist at CIBC Private Wealth, "but the economy will probably muddle through this." He predicts at least one interest-rate cut before year-end, and possibly a second.

Some Wall Street observers are even more aggressive.

If oil prices decline, Citibank economists insist the Fed will cut rates three times this year. The aim would be to bolster a stagnant labor market and drum up demand in key areas of the economy such as housing that have suffered from high borrowing costs.

Iran war over?

The newfound optimism rests on the delicate assumption that the conflict between the U.S. and Iran is not going to get worse.

A cease-fire has been in place for a week and there's little sign full-scale fighting is about to resume. On Friday, a senior Iranian official claimed the key Strait of Hormuz was open to oil-tanker traffic again.

With the conflict on hold, the price of oil has fallen 27% to $82 a barrel from a four-year high of nearly $113 a week and a half ago.

The U.S. stock market, in turn, has recovered most of what it lost after the war broke out, and the S&P 500 SPX even hit a record high this week. Wall Street has essentially declared the war is over.

The bad news is, oil prices are still almost 30% higher than before the conflict began.

The U.S. economy is not as susceptible to high oil prices as it used to be, however.

For one thing, the U.S. is more energy efficient. Millions of people now own hybrid or electric cars, and gas vehicles get better mileage, too.

Businesses also need less gas and oil, especially since the U.S. has become dominated by service-focused companies instead of energy-intensive manufacturing.

"The declining oil intensity of the U.S. economy means it is less vulnerable today," said Michael Pearce, chief U.S. economist at Oxford Economics.

That's not all.

The semifrozen flow of oil in the Mideast has meant a boom for the U.S. Gulf Coast. American oil producers and refiners are reaping a bonanza from a surge in demand and higher prices. That money is going to flow back into the U.S. economy.

Some Americans are being hit hard, of course, particularly middle- and lower-income Americans and anyone who needs to drive long distances for work. Higher oil prices are soaking up more of their discretionary funds.

Typically when oil prices rise, overall consumer spending tends to suffer. Consumer spending is the main engine of the economic growth.

Yet the U.S. economy has navigated prior episodes of high oil prices with little or no damage.

Oil prices surged, for instance, after the Russian invasion of Ukraine in early 2022. The economy kept growing at a rapid pace, although massive pandemic-era government subsidies played a key role.

More relevant, the price of oil soared in 2011 in the wake of the Arab Spring political movement and the civil war in Libya. The cost of a barrel of oil averaged $96 over the next three years.

What did the the U.S. economy do?

The rate of inflation, using the Federal Reserve's preferred personal consumption expenditures price index, jumped from 1.8% in 2010 to 2.5% in 2011, but it fell back below 2% in the following two years, even though oil prices remained high.

What's more, economic growth chugged ahead. Gross domestic product grew at an average of 2.3% a quarter during the three-year span.

Inflation at its 'core'

Most economists see a similar scenario playing out in the months ahead. Oil prices will fade further and the rate of inflation will begin to slow again.

Just not right away.

The PCE price index for March, due in two weeks, is likely to show the rate of overall U.S. inflation rising to a nearly three-year high of 3.4%, up from 2.8% in the prior month.

It won't stop there. Previous increases in oil prices are likely to push the rate of inflation to as high as 3.7% by June, Oxford estimates. Some forecasts even see inflation reaching 4% for the first time since 2023.

Such dismal inflation figures would appear to rule out any further Fed rate cuts this year. The central bank has been trying - and failing - for five years to reduce inflation to an annual rate of 2%.

There's a big catch, though.

The Fed puts more weight on the part of the PCE index that strips out energy - the so-called core rate. Up-and-down oil prices can temporarily exaggerate underlying trends in inflation.

The core rate of inflation is expected to climb to around 3.2% in the 12 months that ended in March, from 3% in the prior month.

Yet many economists contend the core rate of inflation is likely to begin to ease after March or April and start tracking toward 2.5%.

They point out that the core rate has been more stable than headline PCE inflation, hewing closely to a range of 2.8% to 3% in the past two years.

"Core inflation is relatively steady, which suggests the broader economy isn't overheating," said Gina Bolvin, president of Bolvin Wealth Management in Boston.

Once core inflation begins a glide path lower, the Fed will have enough justification to cut interest rates, especially if hiring remains unusually weak.

"The core rate could move to 2.5% by the end of the year," Donabedian said. "That qualifies in a turbulent environment as good enough for the Fed to cut rates."

Another X factor is the reaction of consumers. Citibank economists argue that people have become very resistant to paying more for goods and services after years of stubborn inflation.

The Fed's latest "beige book" survey of the economy also found evidence of "increased price sensitivity" among consumers feeling the financial strain of so much inflation in the past five years. Their unwillingness to tolerate higher prices could also drive inflation lower.

"Businesses are likely to face resistance to higher prices this year as the consumer is losing momentum," economist Katherine Judge of CIBC Economics wrote in a research note.

-Jeffry Bartash

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04-17-26 1140ET