MW Strike on Iran, Trump tariffs could drive inflation back up to highest levels in two years

By Vivien Lou Chen

'More near-term inflation may make the Fed wary of cutting rates imminently,' says James Knightley, ING's chief international economist

U.S. inflation remained surprisingly muted through May, with limited impact from President Donald Trump's tariffs. But U.S. airstrikes on Iran's nuclear facilities over the weekend could contribute to pressures that may send price gains back to the highest levels in two years.

That's according to James Knightley, the New York-based chief international economist for Dutch banking and financial-services company ING $(ING)$. He sees a chance that oil could reach $120 per barrel, up from around or slightly above $74 per barrel now, which would send gas prices to $5 a gallon, versus a current national average of $3.22 a gallon. And that in turn has the potential to send headline U.S. inflation to levels not seen since 2023, starting in the second half of this year, Knightley said.

For now, market participants were still weighing the ramifications of the direct U.S. involvement in the Israel-Iran conflict. Crude oil prices (CL.1) seesawed between modest losses and gains and all three major U.S. stock indexes DJIA SPX COMP turned lower during the New York afternoon, with the current state of Iran's nuclear program far from clear.

The primary mechanism by which events in the Middle East could translate into pain for U.S. households and businesses is through sharply higher global market prices, Knightley said in a note distributed on Monday.

"With tariff induced price hikes already set to squeeze household spending power, higher gasoline prices would intensify the strain on consumer pockets - risking a more pronounced slowdown in the economy. Inflation may well push above 5% in such a scenario while private wage growth is rising only 3.5%," Knightley wrote.

Meanwhile, "more near-term inflation may make the Fed wary of cutting rates imminently," the economist added. "But as with the tariffs, this would likely be seen as a relatively short-term spike that risks a weaker economy over the next 6-12 months [and] that could lead to more aggressive rate cuts in early 2026."

Fed-funds futures traders appeared to agree. As of Monday, they were pricing in a 95% chance of between two and five quarter-point rate cuts through June of next year and weren't seeing a risk of any interest-rate increases.

Recent inflation readings have been tame, with consumer prices rising only 2.4% on a year-over-year headline basis during May. The Fed's preferred price gauge, the personal-consumption expenditures price index, is set to be released on Friday and is expected to produce a 2.3% year-over-year headline reading for last month, up slightly from 2.1% in April.

In an email sent to MarketWatch, Knightley elaborated on his thinking about why rate hikes are unlikely.

Policy makers "would likely take the view that tariff-induced price hikes and oil prices surging would be demand destructive and actually dampen inflation over the medium to longer term. Therefore it would make sense to 'look through' any near-term spike." he said. Still, "the Fed will be wary of easing quickly" and "we suspect they will be watchful over the next couple of months, but respond swiftly if economic weakness materializes."

Seth Carpenter, chief global economist at Morgan Stanley $(MS)$, also sees reasons that higher oil prices may not necessarily translate into rate hikes. In a note, Carpenter said that "higher oil prices feel inflationary, but they could ultimately mean downside risk for the Fed."

He continued: "Around the world, our economics teams have estimated the pass-through of oil prices. For the U.S., the story for inflation is quite modest. History suggests that a 10% permanent increase in oil prices moves core inflation by only a couple of basis points, an amount that easily gets lost in the noise."

-Vivien Lou Chen

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June 23, 2025 12:45 ET (16:45 GMT)

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