Climate disruption could prolong inflation. Look to refiners, tanker operators and agricultural stocks.
El Niño creates severe weather conditions globally. Powerful storms can cause widespread damage, as seen in this 2016 photo of homes in a Northern California coastal community.
Kevin Warsh's first big test at the Fed won't come from the Middle East - it will come from the weather.
There's an inflation risk that could take U.S. rate cuts off the table until 2027. It isn't oil and energy prices. It's El Niño.
El Niño is a global climate pattern that can bring heavy storms and severe drought. In the northern U.S., it portends unusually dry and warm weather, while the Gulf and Southeast states experience abnormally wet weather. California and the Southwest U.S., meanwhile, are hit with torrential rain and mudslides.
The 2026 El Niño is expected to be extremely powerful, according to forecasters at the the National Oceanic and Atmospheric Administration, who see an 81% chance of a "very strong El Niño from October to December that would rank among the largest El Niño events in the historical record going back to 1950."
It's possible this year's conditions could grow into a rarer and fiercer "super El Niño." The most recent occurrence, in late 2015 and early 2016, resulted in an estimated $3.9 trillion in economic losses worldwide, though the U.S. escaped relatively unscathed.
This time around, the U.S. may not be so fortunate. The strengthening El Niño is arriving on top of an oil-supply shock caused by the disruption in the Strait of Hormuz. Together, they could turn a temporary jump in energy prices into a broader inflation problem and put new Federal Reserve Chair Kevin Warsh in a difficult position.
Oil is only the first link in the chain
At his most recent congressional testimony, Warsh said the U.S. central bank has "no tolerance" for persistently elevated inflation. He has also distinguished between ongoing inflation and one-time price increases caused by supply constraints.
That distinction is about to be tested.
The Fed cannot produce more oil, reopen a shipping lane or improve crop yields. As former Fed Chair Jerome Powell said at his March press conference, central bankers typically look through temporary energy shocks when setting interest rates. That makes sense. Higher rates can suppress demand; but they cannot fix the underlying supply shortage.
But repeated supply shocks can eventually spread beyond the products directly affected.
Businesses raise prices to preserve margins. Workers demand higher wages to recover lost purchasing power. Consumers begin to assume that inflation will remain elevated. What starts as a temporary increase in the price level can become embedded in the broader economy.
That is where the Iran war and El Niño become relevant to monetary policy.
El Niño: The next shock
El Niño does not produce the same weather everywhere. It shifts rainfall and temperature patterns across major agricultural regions, increasing the odds of drought in some areas and excessive rain in others. Strong events can disrupt harvests, reduce crop yields and lift global food prices.
They can also affect energy markets. Hotter conditions raise electricity demand, while drought can reduce hydroelectric generation and increase reliance on natural gas and other fuels.
While any individual effect might be manageable, the danger comes from the sequence. The Iran war drives oil higher; consumers pay more at the pump; companies absorb higher transportation costs; and headline inflation rises.
Then El Niño begins affecting food supplies and electricity markets. Households that have only begun to adjust to higher gasoline prices get hit with another increase in essential expenses.
That could make a supposedly temporary inflation shock last much longer than expected.
Warsh should resist reflexive rate hikes
Raising rates would only suppress demand without producing another barrel of oil or improving the weather.
A supply shock would create the worst kind of trade-off for Warsh and the Fed.
These events push inflation higher while reducing consumers' purchasing power and slowing economic growth. But raising rates would only suppress demand without producing another barrel of oil or improving the weather.
The right response depends on whether the shock remains concentrated or becomes embedded in the U.S. economy. Warsh will likely watch the five-year forward inflation expectation rate, which remains near the Fed's 2% target.
Warsh should watch wages, service-sector inflation and longer-term inflation expectations. If those measures remain contained, the Fed can hold rates steady and allow the initial price increase to pass through the data.
If businesses and households begin treating 3% or 4% inflation as normal, the calculus changes. The Fed would then need to respond, even though the original problem began outside its control.
This is why the most likely consequence of El Niño may be fewer rate cuts rather than immediate rate hikes.
How to play the next inflation shock
Holding rates higher for longer would give the Fed time to determine whether the shock is fading while preserving its inflation-fighting credibility. It would also avoid adding unnecessary pressure to an economy already absorbing higher energy costs and multi-decade-high Treasury yields.
For investors, this backdrop should create clear winners and losers. On the long side, favor companies that benefit directly from tighter energy markets rather than merely surviving them. Refiners such as Phillips 66 (PSX) can benefit from stronger refining margins, while tanker operators such as International Seaways $(INSW)$ may benefit from longer shipping routes and tighter vessel availability. Agricultural businesses could also outperform if El Niño disrupts harvests and pushes crop prices higher.
I recently published a broader list of stocks positioned to benefit from this environment in my Substack, "Let's Analyze." The key portfolio lesson is to be careful with companies that depend on falling rates, cheap financing and resilient consumer spending. Higher oil and higher Treasury yields can pressure long-duration growth stocks, housing and weaker consumer businesses simultaneously.
Even if the Iran conflict cools and oil stabilizes, a powerful El Niño could keep pressure on essential prices through the end of 2026 and into 2027. NOAA sees a 97% chance that El Niño persists into early spring.
So while the Iran war may deliver the first inflation shock, El Niño could prevent it from fading quickly enough to restore rate cuts.
Warsh cannot control the weather or keep the Strait of Hormuz open. His first major test will be deciding how long to tolerate supposedly temporary price increases before "higher for longer" becomes the Fed's only realistic option.
Robert Ross is the founder of TikStocks and author of "A Beginner's Guide to High-Risk, High-Reward Investing" (Adams Media, 2022). A former chief equity analyst at Mauldin Economics, Ross writes the investment newsletter Let's Analyze on Substack and hosts the weekly "Room to Run" podcast.
More from Robert Ross:
Yes, the AI stock selloff looks terrifying. But it might actually save the bull market.
The stock market has a 'Magnificent Seven' problem - but not the one bears are warning about
-Robert Ross
Comments