As the war with Iran continues in the Middle East, the US economy is facing dual pressures. On the one hand, soaring oil prices are pushing up energy costs and accelerating inflation risks; on the other hand, some market traders are beginning to worry that the heavy blow to consumer spending from high oil prices could drag the economy into recession, leading to deflation where prices and demand decline simultaneously. Such deflationary consequences are often more difficult to deal with than inflation because the Federal Reserve will have extremely limited room for monetary policy maneuvering.

The energy shock is already apparent: gasoline prices are approaching $4 per gallon.

As of Thursday, March 26, the average gasoline price across the United States had risen to nearly $4 per gallon. This increase amounts to a hidden tax on consumers, directly squeezing household disposable income. The longer the war lasts, the higher the risk of energy supply chain disruptions and the more significant the negative impact on the U.S. economy.



With oil prices rebounding above $100 a barrel, there are no signs of runaway inflation expectations in the market. On the contrary, some indicators suggest that the long-term inflation outlook has even softened. This is precisely the core of the current market concerns.

The sharp decline in 5-year/5-year inflation swap rates foreshadows potential trouble.

In financial markets, the key indicator of the "5-year/5-year inflation swap rate" reflects investors' expectations of the average annual inflation rate over the next 5 to 10 years. Since the outbreak of the military conflict on February 28, this indicator has seen a significant decline. According to Bloomberg data, the swap rate was close to 2.4% on Thursday, down from over 2.5% in January and nearly 2.55% last summer.

Despite a sharp rise in Brent crude futures prices, this long-term inflation expectation indicator has generally declined, indicating rising market concerns about weakening economic growth.

Hu Gang, an inflation trader at New York hedge fund WinShore Capital Partners, pointed out: "Compared to structural high inflation, the market is actually more worried that the initial energy shock will lead to weaker economic growth and may trigger deflation . If I had to place a bet, I would agree with this view."

He further added, " The oil shock is likely to be inflationary in the short term, but deflationary in the long term. The longer the war lasts, the greater the blow to the U.S. economy. " He believes the U.S. economy may already be weakening, and every day gasoline prices remain at current levels will reduce consumer spending in other areas.

The formation mechanism and historical lessons of deflation risk

The vicious cycle of deflation typically manifests as follows: rising oil prices severely impact consumer spending, leading to decreased demand, reduced business revenue, which in turn triggers further price declines and a contraction in economic activity.

The Federal Reserve struggles to cope effectively in a deflationary environment because interest rates are already close to the zero lower bound, and traditional interest rate cutting tools have limited effect.

The last time the United States experienced a significant price decline was from March to October 2009, during the economic recession triggered by the bursting of the housing bubble. That recession, which lasted from December 2007 to the end of June 2009, led to a sharp drop in consumer demand and a period of price decline.

Japan's prolonged period of price stagnation or decline from the 1990s to the end of 2022 is often regarded as a classic example of deflation.

Hu Gang stated, "Everyone has their own views on inflation and deflation, but I don't think it will be a one-sided trend. What we can be sure of is that inflation volatility will increase. It will be difficult for the inflation rate to remain at 2% (which is the Fed's target), but we are likely to see an inflation rate of 3% or 1%."

He added that in this environment, short-term government bond yields (such as 2-year U.S. Treasury bonds) will experience extreme volatility, while the performance of long-term bonds and stocks remains uncertain, but overall, the volatility of financial market assets will increase significantly.

Hu Gang has a relatively accurate track record in inflation forecasting. In July 2022, when the overall Consumer Price Index (CPI) jumped to 9.1% year-on-year, he warned that "inflation will be more stubborn than most people imagine." In February 2023, he further stated that the inflation rate might take more than a year to decline significantly, and that the Federal Reserve would have room to cut interest rates; however, the Federal Reserve did not actually begin cutting interest rates until September 2024.

Market reaction and differing opinions

On Thursday, as the war with Iran neared its one-month mark, financial markets were once again shrouded in concerns about accelerating inflation. The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all closed lower, and the yields on 2-year and 10-year U.S. Treasury bonds rose to 3.98% and nearly 4.42%, respectively, reaching their highest levels since June and July of last year at 3 p.m. ET. The surge in yields pushed up borrowing costs, including new mortgage rates. Meanwhile, bets by federal funds rate futures traders showed that the probability of a Federal Reserve rate hike before the end of December had risen to 46.5%, up from 20.2% the previous day.

However, not all market participants agree with the assessment of the risk of deflation. Brian Mulberry, senior client portfolio manager at Chicago-based Zacks Investment Management, said, "I still think it's unlikely because we need more evidence. We certainly expect rising energy prices to have some impact, but probably not enough to warrant concerns about a significant reduction in consumer spending compared to the past."

Gary Schlossberg, global strategist at the Wells Fargo Investment Institute in San Francisco, also noted that deflation "is certainly possible, but not our base case." He added, "We still believe that such cascading events could be mitigated by some positive developments. We think the likelihood of deflation is smaller than an early end to the war and a drop in fuel prices in the next month or two."

Goldman Sachs commodity strategists predict that Brent crude will average $105 a barrel in March, rise to $115 in April, and then fall to $80 in the last three months of the year. In an unfavorable scenario, oil prices could peak in the $140-$160 range.

Summary: The economic costs of a protracted war

The ongoing war with Iran has exposed the United States to the dual risks of accelerating inflation and potential deflation. In the short term, rising energy prices are pushing up consumer costs and overall prices; in the long term, if the war drags down economic growth and suppresses demand, deflationary pressures may gradually emerge. Whether it's inflation or deflation, increased volatility will bring greater uncertainty to financial markets.

Investors and consumers need to closely monitor developments and the Federal Reserve's policy options in this complex environment. An early end to the war will be key to alleviating these economic pressures.