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March 13, 2026 | 14:43
Shifting Winds—Factoring the War into Our Forecasts
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Shifting Winds—Factoring the War into Our Forecasts |
| A major conflict with Iran was not at the top of our bingo card when we drew up our 2026 economic outlook back in December. Though to be fair, geopolitical uncertainty was top of mind as an important downside risk that investors needed to be monitoring closely. But here we are, nearly two weeks into this new war with Iran, and it’s time to start planning for the collateral economic damage on U.S. consumer spending, economic growth, and inflation. The Fed is now facing its second major supply shock in two years, further complicating its plans to bring down inflation and normalize interest rates. The shifting winds of war will bring unanticipated consequences for all. |
| While conditions across much of the Middle East and Strait of Hormuz remain fluid as war rages and WTI crude oil prices ricochet between $80 and $117 per barrel, we expect the Strait could be shuttered for weeks, if not months, and Persian Gulf oil production will be severely curtailed, cutting global oil supplies by around 20%. Pledged emergency global oil reserve releases can help cushion the extent of price increases for a couple of weeks, but the world has never seen the Strait of Hormuz completely shuttered like this before. This conflict still has the potential to be a major oil supply shock (perhaps one of the worst) that pushes up prices for gasoline, airfares, transportation, food, and other goods while weakening real consumer spending and GDP growth. We are taking a weighted-average scenario approach to forecasting potential oil price shocks and durations to arrive at an average oil price for the year of around $75 per barrel, up from $60 prior to the conflict. This lifts headline CPI inflation about 0.6 percentage points above our pre-war estimates for the year, closing in around 3.0% y/y instead of moderating back down to 2.4%. CPI inflation is expected to accelerate to 3.5% y/y in the second quarter (4.5% a.r.) before easing oil prices start to bring the inflation rate back down (Chart 1). These new inflation forecasts will be adjusted as events transpire and the outlook for global oil prices shift. While the forecast changes are not yet astronomical, the shift toward higher inflation will almost certainly delay the Fed’s next rate cut at least until September, and maybe even longer if oil prices don’t moderate as much as we expect in the second half of the year. We are shifting our Fed call to only two quarter-point rate cuts in September and December of this year with no further cuts in 2027, bringing the Fed funds rate back down its long-run neutral rate of 3.125% by year-end (Chart 2). The negative impact on consumer spending and GDP growth is expected to be about half as large as we see on the inflation front. The U.S. is now a major oil producer and consumer, so some industries and regions of the country will benefit from higher oil prices. Capital spending on AI is likely to remain robust this year no matter where oil prices and the stock market ultimately land. The silver lining on the growth outlook is that the U.S. is still a long way from outright recession. However, if combined with a severe and prolonged stock market correction of 20% or more, the hit to consumer spending and economic growth would be significantly magnified. We cut our U.S. GDP growth forecast for 2026 by three-tenths of a percentage point this week to 2.2%, from 2.5% prior to the war. Our Q1 GDP estimate is lowered to 2.3% a.r. from 2.7%, and Q2 and Q3 are now expected below 2.0% at 1.7% and 1.8% a.r., respectively. The main driver of the downgrade is a more cautious consumer. We forecast real consumer spending growth of 2.0% in Q1 slowing to 1.6% in Q2 before partially recovering to 1.8% in Q3 (Chart 3). If inflation and gasoline prices stay higher for longer into the second half of the year—or the stock market plunges—we could see further cuts to consumer spending. |
Next week’s FOMC meeting and presser will be the first opportunity for Jay Powell and the FOMC to weigh in with their updated forecasts for GDP, unemployment, and inflation. Powell will likely acknowledge the rising two-sided risks to the dual mandate from the oil price shock and highlight the heightened level of uncertainty. But in the end, the Fed’s message will be to wait it out, like last year, until the shifting winds on growth and inflation play out and the path for further rate cuts becomes clearer. |
Oil Fueling Fed Hesitancy |
| The spike in oil prices owing to the Iranian conflict is stoking stagflation risk, at a time when job growth has already slowed to a crawl and inflation is still uncomfortably sticky. For February, payroll job growth averaged 13k over the past year and just 6k over the past three months. Household-surveyed employment plummeted more than one million during the last two months, the worst reading since the onset of the pandemic. Meanwhile, total and core CPI inflation were 2.4% y/y and 2.5% y/y, respectively, with both three-month trends faster at 3.0% annualized. And the (lagged) PCE price metrics are running even hotter. For January, total and core inflation were 2.8% y/y and 3.1% y/y, respectively, with both three-month trends at least 3½% annualized. In the last post-FOMC presser (January 28), Chair Powell asserted that the “tension” between the Fed’s price stability and maximum employment goals had lessened… “I think that the upside risks to inflation and the downside risks to employment have probably both diminished a bit” and now it is about “how you weigh the risks.” Amid higher oil prices and some erosion in business and consumer confidence, we reckon both risks have risen with a skew to the upside for inflation. We look for Powell to highlight these higher, skewed risks in the March 18 press conference. We also look for the Fed to keep policy rates unchanged, with the target range for the fed funds rate at 3.50%-to-3.75%. This will mark the second consecutive hold after 75 bps of rate cuts during the final three meetings of 2025. Recall the year began with a nine-month pause owing to heightened economic policy uncertainty—which has started drifting up again—and the stagflation risks posed by tariffs—which are now being posed by oil prices. In other words, the 2026 edition of policy pause could last just as long (or possibly longer). With policy rates already “within a range of plausible estimates of neutral,” the Fed was going to move more cautiously anyway this year. And now, against the background of mounting stagflation risk and economic policy uncertainty, the caution flag is waving more vigorously. Consequently, we have modified our forecast and now expect two quarter-point rate cuts this year starting in September (it was three beginning in June before). The (OIS) market has also chopped its expectation, from 2.4 moves just before the conflict with Iran began to about one action currently. The FOMC’s median fed funds forecast in the ‘dot plot’ is unlikely to change from December, with single quarter-point cuts expected this year and next. Elsewhere in the Summary of Economic Projections (SEP), we await stagflation-themed adjustments to the other medians. The previous projections for 2026 Q4 were: real GDP 2.3% y/y, unemployment rate 4.4%, total PCE inflation 2.4% y/y, and core PCE inflation 2.5% y/y. We look for a one-tenth downward adjustment in growth and a one-tenth upward adjustment in joblessness and core inflation. Oil prices-influenced headline inflation could see a 0.2 ppt (or higher) increase. Bottom line: With inflation pressures bubbling, job growth seemingly grinding to a halt, and lots of uncertainty surrounding the paths for oil prices and the economy, we reckon the Fed will end up tearing a page from an early-2025 playbook… “the appropriate thing to do is to wait and see how things evolve.” |
Inflation Was Already Heated Before the Iran Conflict |
| This was not a great week for inflation doves. Not only is it looking less likely that oil prices will make a hasty retreat, but the two main measures of U.S. inflation are flashing some heat. While steady CPI headline and core annual rates in February (2.4% and 2.5%) are somewhat comforting, you don’t need to dig deep to find pressures burbling beneath the surface. True, it is encouraging that rents are moderating, new and used vehicle prices are down from a year ago, and electricity prices are starting to roll over. And, it is reassuring that the earlier tariff push appears to be fading, as core goods inflation has risen just 0.6% annualized in the past three months. However, services inflation is proving a much tougher nut to crack, up 2.9% y/y and 3.8% annualized from three months ago. This is only partly due to stubborn medical care costs, which are up 3.4% y/y as an aging population fans demand and staffing shortages. Even so, health care added just 0.1 ppts to headline inflation in the past year. Of real concern, core CPI prices are running at a 3.0% annualized rate in the past three months. Even compared with the three-month period before October’s shutdown-related noise, this rate is running hot at 3.8%. The Cleveland Fed’s median and trimmed-mean CPI metrics, though moderating in the past year, also remain elevated at 2.8% y/y and 2.7%, respectively. And speaking of elevated, the Fed’s preferred inflation measure, the personal consumer expenditures (PCE) price index, is up 2.8% y/y in January, seemingly locked around this pace for the past six months (and, of course, poised to shoot much higher amid soaring energy costs). Core PCE inflation edged up to 3.1% y/y, a near two-year high and up from the cycle low of 2.6% reached last April before reciprocal tariffs kicked in. Excluding energy services and housing, services costs rose 3.5% y/y. On a three-month annualized basis, PCE prices are up 3.5%, core prices 3.7%, and core services prices 4.3%, all heading in the opposite direction of the Fed’s target. Nor can the blame be placed solely on health care services, which rose 3.6%. Price increases are broad-based, spanning a range of other services, including recreation, finance, restaurants, and hotels. Historically, core PCE and core CPI inflation track each other closely, with the former typically running slightly lower. Core CPI is the more volatile of the two measures and tends to converge toward the PCE metric over time. So, while the true rate of inflation may lie somewhere between the two, it likely leans closer to the higher PCE metric. The upshot is that, while there are some signs of progress in the U.S. inflation data, such as contained goods costs despite tariffs, the bigger picture is one of lingering stickiness on the services side, even outside health care. The unsettling message for policymakers and consumers is that inflation, even after peaking in 2022, was not fully under control prior to the onset of the Iran conflict. Affordability could remain a major sticking point for many Americans, particularly lower-income families, for a while. |
Oil Shock: The Same, but Different |
| Oil price shocks are not new for the economy, but their impact has evolved. There are a number of factors that will help cushion the impact during this episode, and a few things still to worry about. We still judge that the net risks land on the upside for inflation and downside for growth, although more moderately so than in the past. |
| The economy is less energy-intensive today than during past oil price shocks. At roughly 20 million bpd of consumption, that’s less than 0.7 barrels to produce $1,000 of real GDP (in 2025 dollars). That compares to around 1 barrel 20 years ago; and more than 2 barrels during the bad days of the 1970s shocks. If we scale the current surge in oil prices for the fact that intensity is lower, it suggests there is plenty of room still between where we are now and the type of shocks that seriously derailed growth or triggered recessions (Chart 1). In fact, in those terms, you’d probably need to see WTI push to the $120-to-$140 range to match the magnitudes seen during the Russian-Ukraine conflict, the pre-GFC run-up or the early-1990s Iraq invasion of Kuwait. |
The U.S. is also a major oil producer now, and a net exporter of energy products, a stark change from decades past. The U.S. produces a record 14 million barrels per day, up from just 5 million at the onset of the financial crisis and around 7 million in the early 1990s. While domestic production could be slow to respond as firms push to improve balance sheets, production should ultimately chase prices higher—and U.S. production is agile. A number of regions will see a positive impact from stronger earnings, income and, eventually, output. Higher energy efficiency over time, and a general softening in prices, have pulled the weight of energy in the CPI down to around 6.4%, the low end of the range (6%-to-12%) seen since the 70s. So, while there will be immediate passthrough to headline inflation, the magnitude to start should be at the low end. The stage of the cycle also matters, and it helps that this shock is set against a backdrop that was seeing sturdy economic growth (especially private domestic demand), healthy earnings, disinflation and Fed easing. On the flip side, while efficiency has improved, the consumer still accounts for a near-record 68% of GDP. The confidence impact of a drawn-out conflict, in addition to the direct impact on disposable income and inflation expectations, still matters. On the household balance sheet, equities and related holdings now make up a near-record 53% of financial assets, leaving the consumer exposed to a deterioration in financial conditions. The concern is that higher inflation prevents the Fed from easing, thus removing an expected support for already-stretched valuations. Finally, tools like the SPR can be used to dampen price movements, but those reserves in the U.S. have thinned. This week’s announced 172 mln barrel release (400 mln by the IEA in total) was swallowed by the market. Recall that the U.S. SPR was already drawn down by more than 250 mln barrels during the Russia-Ukraine conflict, and had only been rebuilt by less than a third. After this week’s announcement, current levels will be running at around 240 mln barrels, the lowest level since the early-80s. |