Industrial: How do high oil prices affect US inflation and Federal Reserve actions?

Industrial issued a research report stating that since the escalation of the situation in the Middle East, oil prices have clearly increased compared to before the US attack on Iran. Although oil prices have fallen somewhat due to President Trump's quick statement to end the conflict and various countries releasing oil reserves, the uncertainty in the current geopolitical situation remains strong, and the risk of oil price increase has not ended. The subsequent judgment of oil prices needs to pay attention to the situation in the Strait of Hormuz and how other economies respond to the tightening oil supply as two core clues. In addition, the core clues for pricing interest rate cuts have shifted from inflation data to oil prices, considering the "scarring effect," the Federal Reserve's judgment is expected to be more cautious regarding the upward trend in inflation relative to 2022. The main points of Industrial are as follows: The escalation of the situation in the Middle East, transportation disruptions in the Strait of Hormuz, rapid increase in international oil prices, and amplified fluctuations. Since the escalation of the situation in the Middle East, oil prices have clearly increased compared to before the US attack on Iran. Although oil prices have fallen somewhat due to President Trump's quick statement to end the conflict and various countries releasing oil reserves, the uncertainty in the current geopolitical situation remains strong, and the risk of oil price increase has not ended. The subsequent judgment of oil prices needs to pay attention to two core clues. One is the situation in the Strait of Hormuz, including the continuity of conflicts in the Middle East, the deployment of mines by Iran, and the implementation of US military escorts; the other is how other economies respond to the tightening oil supply, including the progress of energy inventory releases coordinated by IEA member countries. The core clues for the pricing path of interest rate cuts have shifted from inflation data to oil prices. In February, the US CPI performance was in line with market expectations, with a slight decrease in core CPI month-on-month, but the US dollar and US bond yields continued to rise against the backdrop of rising oil prices, indicating that the core focus of the current pricing path for interest rate cuts has shifted to oil price movements and their transmission effects on US inflation. How does changes in oil prices affect US inflation? Direct impact: Based on the transmission path of "international oil prices gasoline retail prices energy CPI overall CPI," a 10% increase in oil prices has a direct pulling effect of about 0.14 percentage points on the overall US CPI. Second-order transmission: If oil prices remain high, it will lift core inflation. A rise in oil prices has a statistically significant upward impact on core inflation. Compared to the impact on overall CPI, it has characteristics such as a longer transmission period, smaller increase magnitude, and longer duration. According to the Federal Reserve's model, a 10% increase in oil prices will raise the overall inflation rate in the US by about 0.15 percentage points, with the "second-order transmission" effect on core inflation being about 0.06 percentage points. Inflation forecast: If the WTI oil price remains at $70 per barrel from March to the end of the year, the midpoint of the US CPI year-on-year change will be around 2.87% this year; if the WTI oil price rises and stays at $80 per barrel, $90 per barrel, and $100 per barrel until the end of the year, the midpoint of the US CPI year-on-year change will be 3.08%, 3.30%, and 3.51% respectively. The impact of oil price shocks on the midpoint of the US CPI year-on-year change is roughly the same as the calculation results of the Federal Reserve's model. However, if the US-Iran negotiations make progress, the Strait of Hormuz resumes transit, and international oil prices briefly spike before falling back, their upward effect on US inflation this year will be significantly weakened. From historical experience, the impact of rising oil prices on US core inflation is significantly higher than theoretical results, and the transmission lag is also affected by demand strength. Analyzing the trends of US core CPI during the rapid rise in oil prices in 2009 and 2020, it can be seen that although some of the rise was driven by demand recovery, the increase in core inflation after the rapid rise in oil prices was significantly higher than theoretical results, and there is a certain lag between "oil price rise core inflation increase." At different times, due to differences in domestic demand strength in the US, the transmission time from oil prices to core inflation also varies. Consumer purchasing power determines the magnitude and transmission lag of the impact of rising oil prices on core inflation. The current lower and middle-income groups have stronger demand than in 2009 but not as much as in 2022, therefore it is expected that the second-order increase in core inflation will not occur until at least the first quarter of 2027. If rising oil prices push up inflation, how will the Federal Reserve respond? Considering the "scarring effect," the Federal Reserve is expected to be more cautious about the upward trend in inflation compared to 2022. On the one hand, Federal Reserve Board of Governors member Lael Brainard has a hawkish stance during his tenure, with a lower tolerance for inflation risks. Under the influence of the new Chairman, the Federal Reserve may not necessarily continue the loose policy of "waiting for more confirmation" and may instead adopt a faster response pace. On the other hand, based on statements from Federal Reserve officials in recent months, internal concerns about inflation stickiness have increased within the Federal Reserve. In addition, after the tightening in 2022, market judgments about the Federal Reserve tend to be overly exaggerated, which means that liquidity tightening could lead to more severe pricing. Excessive expectations for tightening could trigger a rapid rise in US bond yields and tightening of US dollar liquidity, amplifying short-term interest rate volatility, which could then lead to liquidity shocks and valuation pressures on risky assets (especially on overvalued technology stocks sensitive to interest rates). How does the disruption in transportation in the Strait of Hormuz affect different economies? In terms of dependency, the disruption in transportation in the Strait of Hormuz has a relatively small impact on US energy supply, but mainly affects Asia, particularly Japan and South Korea. As a net energy exporter, the US is less affected by disruptions in transportation in the Strait of Hormuz on its energy supply. However, Japan and South Korea, with a high dependence on external energy sources, rely heavily on oil tanker transportation through the Strait of Hormuz. If the strait continues to be substantially closed, they may face serious energy shortages, which could then affect economic activities. China has benefited from its recent green development transition and diversified energy import channels, so the overall risk of disruptions in transportation in the strait affecting China's energy supply is manageable. In terms of liquidity, if market pricing brings about monetary policy tightening, the impact on the US will be greater. Currently, the US CPI year-on-year remains above the Federal Reserve's 2% inflation target, and policy rates are at historically moderate to high levels. If the rise in oil prices leads to a significant increase in inflation, the Federal Reserve may have to adopt measures to raise interest rates to curb inflation, which will have a significant impact on the fiscal sustainability and the US stock market, particularly on technology stocks sensitive to interest rates. On the other hand, prices in China are still running at low levels, and policy rates are at historically low levels, so there is a higher tolerance for input inflation brought about by rising oil prices, and there is more policy room for response. Risk warnings Sustained higher-than-expected US inflation, unexpected changes in the Middle East situation.