The Perfect Scapegoat for Tariff Inflation: Oil

What’s Happening: This past weekend, the United States struck multiple nuclear facilities in Iran, supporting Israel’s recent military campaign against the country. Given Iran’s strategic position by the Strait of Hormuz – a vital artery for the global supply of oil – and its substantial oil production, the price of oil noticeably increased. The price per barrel stood at roughly $76, up about 25 percent from May lows, but in the aftermath of the June 23 ceasefire agreement, oil fell back down to around $67 per barrel. The concern in the United States is that a sharp spike in oil prices, perhaps driven by another bout of conflict, will place upward pressure on inflation – and come at the same time tariffs are expected to work their way into the economy via higher consumer prices. As of now, the headline figures for the consumer price index (CPI) and producer price index have not shown any significant impact from higher tariff rates, but certain goods such as appliances and bananas have seen a noticeable month-over-month uptick in prices. Notably, Federal Reserve Chair Powell believes that inflationary pressure from these tariffs will begin to show up in the data this summer, likely in July and August.

Why It Matters: It’s not difficult to envision an outcome in which fighting between Israel and Iran resumes, oil prices rise, and the Trump Administration – looking for a way to distract from the price hikes its tariffs will produce – blames impending inflation on the price of oil. After all, it is difficult to pinpoint the impact of rising oil prices on other economic categories, and the price of oil could rise at precisely the same time as tariff price hikes are anticipated. Oil, and energy generally, is a large determinant of inflation because it is an input for most economic activities, with the most significant being the transportation of goods and services. Not only do Americans feel the direct impact of rising oil prices at the gas pump; they are also indirectly impacted by such prices hikes as the goods they purchase are primarily shipped using gas-powered vehicles. It is estimated that a 20-percent price shock to crude oil would raise CPI by 0.3 percent, which does not fully account for the downstream impact to the overall U.S. economy, as the cost of construction, shipping, and manufacturing would also increase. Meanwhile, the effective U.S. tariff rate has increased from about 3 percent to roughly 15 percent in just five months, a fivefold increase in import taxes for U.S. businesses. Many businesses plan to pass along at least some of the additional tariff costs to consumers, although they seem to be taking a gradual approach due to the fact May failed to show any substantial consumer-price inflation. If the delayed economic response to tariffs aligns with an oil-induced price shock, the administration may attempt to shift the blame and thus cloud the real impact of its tariff policies. Another scenario is that oil prices continue to decline and the recent drop in the price per barrel is maintained for the foreseeable future. This would suppress inflationary pressure from tariffs, shrouding the negative impact on businesses and consumers.

Looking Ahead: The price of oil may hinge on the Middle East ceasefire holding. Rather than speculating on the likelihood of that, let’s rank the potential scenarios for inflation from best to worst case. The unicorn scenario is that oil prices remain low and tariffs are lowered to near 2024 levels, thus lowering inflation, increasing the chance of interest rate cuts, and easing economic stagnation concerns. The best-case, realistic scenario is that oil prices remain low and provide some relief for U.S. businesses and consumers. The worst-case scenario is that oil prices rise, pouring gasoline on an economy already burned by inflation and expecting another round of flames. In the worst-case scenario, the Federal Reserve will be much more hesitant to lower interest rates and stagflation (high inflation mixed with low economic growth) becomes highly likely.