Weekly Wrap-Up: Iran Holds a "Trump" Card; Inflation/Interest Rates/The Fed

Trump's TACO option is constrained. That extends the war's duration. That amps up its econ downsides.

What if Trump can’t TACO his way out of the Iran War?

Here are some of the current facts of the case re the war as I understand them:

—Oil and nat gas flows through the Strait of Hormuz (SoH) are down 96%.

—The price of oil is ~$110/barrel for Brent (global benchmark) and ~$100 for WTI (US benchmark). The average national gas price is up about a buck, from ~$3 to ~$4 per gallon. My SIEPR colleagues and I project that “gas prices will peak at over $4.25 per gallon in May, and that the average household will pay $857 more for gasoline over the rest of the year.”

—Equity markets have been tanking since the war started and the “fear index” (the VIX, a measure of stock-market volatility) closed at 31 on Friday, almost twice its level in normal times, ~17. Interest rates are up (discussed below).

—Information from the Trump administration is non-credible, so no one knows the status of negotiations. But it is clear that the admin misread the Iranian regime’s response. That regime is fighting for its survival which for them means playing the one card they hold: asymmetric warfare—drones and speedboats vs. US/Israeli air power—to keep the SoH closed.

—Iran’s one card means that TACO—Trump declares victory and walks away—is not the option it usually is. As one market strategist told the WSJ: “You can’t TACO on this. In this case, Iran gets a veto, or at least a vote.”

So, how much longer might this war persist? Putting together everything I’m seeing, months may be more likely than weeks. FWIW, you can check the Polymarket odds here; as I write, they’re at 38% for the war ending by mid-May, down from 60% a week ago. I’m sure that decline is related to the news that Trump is sending thousands of US troops to the region.

There is no easy way to reopen the Strait. Naval experts say it is possible for convoys to safely escort cargo ships through the choke point, but it would take an international effort and the number of ships in transit would be severely reduced.

At any rate, if that timeframe is in the ballpark, then expect oil and gas prices to continue to climb. Markets seemed to coalesce around the hope that Brent would peak at $110, but I fear that may be optimistic. Trump’s exit ramp is blocked by Iran’s grip on the SoH, along with his admin’s unwillingness thus far to put boots on the ground, embargo their oil, or shut down their Kharg Island export hub. All of which, ftr, would also take considerable time to implement and recovery from.

If you’re asking yourself how the admin could have walked into this without realizing these risks, the answer is simple: unchecked hubris from an authoritarian leader operating on instinct that is wholly divorced from knowledge. Giving that person the keys to the military is like giving race-car keys to a drunk teenager.

Higher Inflation, Higher Rates, The Fed

The OECD just updated their forecast for US inflation this year from 3% to 4.2%, up from (actual) 2.6% last year. That’s higher than most others I’ve seen, but it corresponds to around where we’d likely end up if the duration of the war is closer to what the prediction markets are expecting. Forecasts for a smaller increase—e.g., inflation rates in the mid-3’s—expect the conflict to wrap up sooner than I fear it might. Another two months of war and its associated supply shocks could make the OECD forecast the modal forecast.

Either way, that inflation rate, even while it’s mostly a headline-rate problem—the core rate, which excludes energy and food prices, shouldn’t rise nearly as much—generates at least three other consequential problems, should it come to fruition.

—Declining real wages: This is my biggest concern. As you see in the figure below, the yearly, nominal growth of middle/low wages slid down from highly elevated, post-pandemic rates, hitting a solid 4% in ‘24/’25. Lately, the softer job market has helped push that rate down such that n Feb, it grew at 3.7%.

I don’t expect labor markets to get stronger any time soon, so I see little scope for faster nominal wage growth. Add in the fact that consumer spending—70% of GDP—has been a key force in US growth in recent years, fueled in part by real wage gains, and you see why this potential hit to real wages could be a big problem.

—Higher food/grocery costs. About a third of the globe’s fertilizer supply goes through the SoH. Ana Swanson of the NYT gets this right:

One of the biggest economic casualties of the U.S.-led war in Iran has been the global fertilizer supply.

Shipments of it have piled up on the wrong side of the Strait of Hormuz. In India, Algeria and Slovakia, fertilizer plants have shut down or slowed their output because of rising natural gas prices. China has restricted fertilizer exports. Australian wheat farmers are planting less, and corn and soy farmers in the United States are begging President Trump for relief.

—One response to these inflationary pressures has been higher interest rates. The ten-year Treasury yield (right axis, below) and it close cousin, the the 30-year fixed rate mortgage, are both up sharply since the war began.

Summing up, an extended war duration will, without doubt, crank up headline inflation. If that then interacts with weak job creation leading to slower nominal wage growth, I’d expect slower, if not declining, real wage gains. Should that bleed into slower consumer spending, as I suspect it would, growth will slow and my recession probability will rise.

Won’t K-shaped dynamics help here, as in high-end consumers keeping the party going? Perhaps, but see the equity markets figure above. A decline of that magnitude will ding both the wealth and the “animal spirits” of share holders, along with anyone foolish enough to check their 401(k)’s recent trajectory.

Finally, can the Fed help with any of this? Right now, they’re wise to stay on hold, as Powell emphasized after their last meeting, as they learn more about where inflation and unemployment are heading given the cuts they’ve made so far and the war’s impact on the economy.

But a number of the points made above suggest that they probably could help with rate cuts should the economy falter. First, I’ve emphasized weaker demand from softening labor markets and slower wage growth possibly bleeding into slower consumer spending. Second, the inflation-juicing war impacts are largely from negative supply-side shocks, and the Fed, as I recently wrote, tends to “look through” those, as its medicine works largely on the economy’s demand side. Third, the Fed may want to do something to push against the rising rates shown above. So, while other nuances are in play (services inflation has been surprisingly high and sticky), notably softer demand (if that’s what’s in store) and negatively-shocked supply should be a recipe for Fed cuts.

What is all of this doing to how people are feeling about the economy? Don’t ask…Actually, do ask, and I get back to that soon. It ain’t pretty, especially as people were already unhappy about affordability…or the lack thereof.