Inflation has been relatively tame so far this year, with the consumer price index rising 2.4% on an annual basis in each of the past two months. The outlook for the coming months is a lot less benign, however.
The surge in oil prices since the Feb. 28 start of the war with Iran is set to drive headline inflation back up to 4% in coming months. Even if oil retreats to well below $100 a barrel and the effects of tariffs moderate, inflation is unlikely to return to the Fed's 2% annual inflation target for at least a few years. Input costs are on the rise due to growing demand for artificial intelligence, firmer labor costs, and other factors.
Inflation has exceeded 2% for the past five years, as Fed Chair Jerome Powell acknowledged in a press briefing on March 18 after the Fed's latest policy meeting. Now the risk is growing that inflation expectations will become unanchored, meaning that households and businesses may come to doubt the Fed's ability to control it.
The price of Brent crude, the international oil benchmark, slipped back under $100 a barrel on Tuesday after President Donald Trump announced he would pause for five days a decision to strike Iran's power plants and energy infrastructure. But the joint U.S.-Israel war with Iran is likely to keep the Strait of Hormuz, a vital shipping lane, largely closed for at least several more weeks, if not months, curtailing global energy supply.
"The situation is highly fluid, but the baseline would have to be at least several weeks, and possibly longer, because it is difficult to see where the common landing zone is," says Nick Redmond, director of analysis and editor in chief at Oxford Analytica.
Closure of the Strait and attacks on the Mideast's energy infrastructure sent oil prices up to nearly $120 a barrel from a range of $66 to $72 a barrel before the war began, although Brent crude, the international benchmark, now trades around $99. The increase in crude has lifted U.S. gasoline prices from around $2.90 a gallon in mid-February to a recent $3.98, according to AAA.
Gas prices surged nearly 22% in March, says Denton Cinquegrana, research and analysis director at OPIS, an oil-price reporting company owned by Dow Jones. That is the highest monthly percentage increase in the past 20 years.
Higher prices at the pump could boost headline CPI inflation by at least 1% in March, to 3.4%, says Alan Detmeister, executive director of Global Economic Research at UBS and a former Fed economist. He sees CPI inflation reaching 4% in April in what he calls "a pretty massive move."
The Bureau of Labor Statistics is set to release the March CPI on April 10.
Even if the oil shock ends soon, the Fed could be looking at above-trend inflation for another few years due to structural changes in the economy, including deglobalization. "The world has changed in a way that has led to an upward tug on inflation," says Karen Dynan, an economics professor at Harvard University and a senior fellow at the Peterson Institute for International Economics. "That contrasts with the first two decades of the 21st century, when globalization and related forces had imparted a downward tug on inflation.
Barring a U.S. recession, which isn't widely expected, inflation is likely to be closer to 3% than 2% this year. Dynan notes that the effects of deglobalization, immigration restrictions, and the upward pressure on energy prices from the buildout of artificial-intelligence-focused datacenters all could lead to higher prices. Higher tariffs are already boosting goods prices as more companies pass on cost hikes this year.
Much of the drop in inflation from an annual peak of nearly 9% in 2022 owes to decelerating price growth -- and even price declines -- in goods. But the trend has reversed lately: Wholesale inflation measured by the producer price index has shown substantial gains in recent months, due in part to rising prices for diesel fuel, electronic components, industrial chemicals, and even meat. And the pressure in the pipeline isn't about to abate.
Any progress toward 2% inflation is likely to come from services, Detmeister says. Shelter inflation, in particular, is expected to trend substantially lower this year due to softening rent growth.
Surveys of renters and homeowners show that key shelter measures in the CPI -- owners' equivalent of rent, and rent -- are cooling slowly, with timelier measures of market moves suggesting more moderation ahead, says Thomas Ryan, North America economist for Capital Economics. Shelter accounts for roughly 40% of the CPI basket (and a smaller percentage of the personal consumption expenditures price index, the Fed's preferred inflation measure), so it can do some "heavy lifting" in bringing inflation down, Ryan says.
Non-housing services inflation may be more problematic. It is highly sensitive to the broader economy, especially the labor market, which remains relatively tight and with decent wage growth. As a result, Detmeister forecasts that inflation won't fall sustainably to within a quarter of a percentage point of 2% until late 2028, as measured by core PCE inflation, excluding food and energy. Core PCE rose 3.1% year over year in January, the latest available reading, while headline PCE was up 2.8% in the month.
Services inflation overall has been stuck in a range materially above pre-Covid levels, driven by stronger demand and the lingering effects of high pandemic-era wage growth. The Trump administration's immigration curbs could lead to tighter labor conditions and more wage growth, pushing services inflation even higher, Dynan says.
To be sure, most economists and investors believe the recent run up in energy prices will be temporary. Additionally, consumer inflation expectations have remained largely well-anchored throughout the postpandemic inflation surge and its aftermath. That has given Fed officials comfort that inflation will gradually drift lower, keeping interest-rate hikes off the table.
Traders are pricing in only an 8% chance that the Fed will hike rates at its April 28-29 policy meeting, according to the CME's FedWatch tool. Still, a one-two punch of surging inflation and higher interest rates would be much more damaging to the U.S. economy than the recent spike in oil suggests.