Industrial Securities has released a research report analyzing how recent Middle East tensions have driven oil prices significantly higher than pre-conflict levels. While prices have retreated somewhat due to statements from former President Trump about swiftly ending hostilities and coordinated releases from national strategic petroleum reserves, geopolitical uncertainty remains high, and risks of further oil price increases persist. Future oil price direction depends on two key factors: navigation conditions in the Strait of Hormuz and how other economies respond to tightening oil supplies. Additionally, market pricing for the Federal Reserve's interest rate cut trajectory has shifted its focus from inflation data to oil prices. Given the "scar effect" from past inflation, the Fed is expected to approach any resurgence in inflation more cautiously than in 2022. The main views of Industrial Securities are as follows.
Middle East tensions have escalated, disrupting shipping through the Strait of Hormuz, leading to a rapid rise in international oil prices and increased volatility. Since the escalation of the Middle East situation, oil prices have risen markedly compared to levels before the conflict. Although prices have pulled back due to factors such as statements favoring a quick resolution and strategic reserve releases, the geopolitical outlook remains highly uncertain, and the risk of further oil price increases is not over. Judging future oil prices requires monitoring two core factors. First is the navigation situation in the Strait of Hormuz, including the duration of Middle East conflicts, Iran's deployment of naval mines, and the implementation of US military escorts. Second is how other economies cope with tighter oil supply, including the progress of coordinated energy stockpile releases by the International Energy Agency and its member states.
The market's focus for pricing the Fed's rate cut path has shifted from inflation data to oil prices. February US CPI met market expectations, with core CPI showing a slight month-on-month decline. However, the US dollar and Treasury yields still rose against the backdrop of rebounding oil prices, suggesting that the market's primary concern for pricing future rate cuts has turned to oil price movements and their pass-through effect on US inflation.
How do oil price changes affect US inflation? Direct impact: Based on the transmission path of "international oil prices → retail gasoline prices → energy CPI → overall CPI," a 10% rise in oil prices directly adds approximately 0.14 percentage points to the year-on-year US CPI. Second-order transmission: If oil prices remain elevated, they will push up core inflation. A rise in oil prices has a statistically significant effect on core inflation. Compared to its impact on headline CPI, this effect features a longer transmission time, a smaller magnitude of increase, and a more prolonged duration. Fed models predict that a 10% increase in oil prices would raise overall US inflation by about 0.15 percentage points, with the second-order transmission effect on core inflation accounting for roughly 0.06 percentage points.
Inflation forecast: If WTI oil prices remain at $70 per barrel from March through year-end, the US CPI average for the year would be around 2.87% year-on-year. If WTI prices rise and stay at $80, $90, or $100 per barrel until year-end, the corresponding US CPI averages would be 3.08%, 3.30%, and 3.51%, respectively. The impact of an oil price shock on the CPI average aligns closely with Fed model estimates. However, if negotiations progress and the Strait of Hormuz reopens, leading to a brief oil price spike followed by a decline, the upward effect on US inflation this year would be significantly weaker.
Historical experience shows that oil price increases affect US core inflation more significantly than theoretical results suggest, and the transmission lag is influenced by demand strength. Reviewing US core CPI trends during the rapid oil price increases in 2009 and 2020 reveals that, although partly driven by demand recovery, the rise in core inflation after a sharp oil price increase was notably higher than theoretical predictions. There is also a lag between oil price increases and core inflation rises, and the transmission time varies across periods depending on the strength of US domestic demand.
Household consumption capacity determines the magnitude and lag of oil price effects on core inflation. Current demand from middle- and low-income groups is stronger than in 2009 but weaker than in 2022. Therefore, a second-round rise in core inflation is not expected until at least the first quarter of 2027.
How might the Fed respond if rising oil prices push up inflation? Considering the "scar effect," the Fed is likely to be more cautious about inflation increases compared to 2022. On one hand, potential chair candidate Kevin Warsh maintained a hawkish stance during his tenure as a Fed governor, showing low tolerance for inflation risks. Under a new chair's influence, the Fed may not延续 a "wait-and-see" approach but could respond more quickly. On the other hand, recent statements from Fed officials indicate growing internal concern about persistent inflation. Furthermore, after the 2022 tightening cycle, market reactions to Fed policy often overshoot, meaning liquidity tightening could be priced in more aggressively.
An overshoot in tightening expectations could trigger a rapid rise in US Treasury yields and a tightening of US dollar liquidity, amplifying short-term rate volatility. This would create liquidity shocks and valuation pressure on risk assets, particularly interest-rate-sensitive, high-valuation tech stocks.
How does disruption in the Strait of Hormuz affect different economies differently? In terms of dependency, Strait of Hormuz disruptions have a smaller impact on US energy supply, with the main effects felt in Asia, especially Japan and South Korea. As a net energy exporter, the US faces minimal energy supply impact from Strait closures. Japan and South Korea, however, are highly dependent on energy imports, primarily shipped via the Strait of Hormuz. A prolonged closure could lead to significant energy shortages, adversely affecting economic activity. China, benefiting from green transition efforts and diversified energy import channels in recent years, faces generally manageable risks to its energy supply from Strait disruptions.
Regarding liquidity, if markets price in monetary tightening due to inflation, the US would experience a larger impact. With US CPI consistently above the Fed's 2% target and policy rates at historically moderate-to-high levels, a significant oil-price-driven inflation increase could force the Fed to raise rates, substantially impacting US fiscal sustainability and the stock market, particularly rate-sensitive tech stocks. In contrast, China currently has low price levels and historically low policy rates, allowing greater tolerance for imported inflation from oil prices and providing more policy flexibility.
Risks include US inflation persistence exceeding expectations and unexpected changes in the Middle East situation.
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