Duration Is Destiny for the Iran War
Three wars, three economies
We have argued since the early days of Operation Epic Fury that the economic consequences of the war in Iran depends less on the price of oil this week than on one question: how long will this last? The Strait of Hormuz constitutes the border between a fear and a shock, and the severity of the shock evolves over time. Wall Street now reports the numbers under this framework, and the estimates are worth examining.
The Bank of America research team mapped three distinct economic scenariosand the results run counter to the market’s reflexive assumption that oil shock equals inflation equals Fed tightening. This assumption is wrong in at least two of the three cases – and dangerously wrong if the Fed itself takes it seriously.
The short war
If the conflict is resolved quickly… Hormuz reopens and global oil supplies return to pre-war levels – damage is minimal. Bank of America estimates that there will be about 15 basis points of additional PCE inflation over the course of a year and about 15 basis points less of growth. These are rounding errors. Brent crude would likely average around $70 a barrel for 2026, according to the Bank of America estimate. In this scenario, the Fed is basically stuck in a wait-and-see attitude. Most Americans would barely notice it beyond the temporary pain at the pump they’ve already experienced.
The average war
If the conflict continues into the spring, the calculus changes. Bank of America expects growth for 2026 to be between 2% and 2.5%, down from a previous forecast of 2.8%, with headline and core PCE inflation ending the year around 3% and the oil average closer to $85.
Inflation is real here, but its sources matter. Direct energy costs drive up gasoline and utilities. The closure of Hormuz, which blocks around 20 percent of the world’s LNG supply, puts upward pressure on natural gas in Europe and Asia, with repercussions on electricity costs. And the effect on fertilizers is underestimated. The Gulf states account for 34 percent of global urea exports and 23 percent of ammonia, with most of it passing through Hormuz. This will not be a “pass-on” story where farmers can simply pass on their higher costs. Instead, the more likely outcome is a supply crisis that will show up in grain yields six to 12 months later, when the Northern Hemisphere’s harvests emerge.
This is also the scenario in which the Fed is the most paralyzed and therefore the most dangerous. Inflation is uncomfortably high, but growth is tepid rather than collapsing. There is no specific gesture. Bank of America expects the Fed to remain frozen unless the unemployment rate begins to trend toward five percent. But, as we explained from the first day of this conflict, the Fed’s credibility scar from the transitory inflation debacle creates an asymmetric temptation: it is much easier for the Fed to demonstrate tenacity by adopting a hawkish attitude than explaining why doing less is the economically correct response when gas prices are rising and inflation headlines are blaring.
This risk is amplified by the The Fed’s Antagonism Toward President Trump and its administration. Former New York Fed President William Dudley argued in 2019 that the Fed “should not enable” Trump’s tariff policies — that it should allow short-term damage to the economy in the name of crushing bad trade policy and hurting Trump’s re-election chances. Dudley wasn’t alone. Many prominent economists have advocated similar approaches, although they are not as explicit. Although few current Fed officials would publicly endorse this view, it is likely that it is in the background of their thinking. Why should they support “Trump’s war” in Iran? Allowing some damage now would worsen the Republican Party’s chances of retaining the Senate or House in the midterm elections, reducing Trump’s power to implement his policies.
This would be a political error. The hawkish nature of the Fed and its resistance to administration policies could risk create a recession. But just because something is stupid doesn’t mean the Fed won’t do it.
The long war
The scenario of a longer quagmire of war is one where conventional wisdom completely collapses. A conflict that extends into the second half of the year does not produce a stagflationary spiral. This produces a contraction, even a recession – even without a Fed error – and recessions are deflationary.
The mechanism is simple. Sustainable oil above $100 destroys demand. Higher-income consumers fall back when stocks correct. Low-income consumers, already strained by energy costs, are seeing delinquencies increase and access to credit tightening. Bank of America estimates that GDP growth would fall to around 1% in this scenario, with more severe variants flirting with an outright contraction. At this point, energy and food inflation are temporary. What is lasting is the collapse in demand. Bank of America notes that when oil fell 50 percent, the Fed cut rates by an average of 154 basis points over the next six months. Even cuts of 100 basis points in a single year would be on the table.
The risk hidden in the three
What Bank of America’s scenario analysis does not fully take into account is a risk that affects all three scenarios. Ben Bernanke – back when he was a Princeton professor rather than a central banker – co-authored research suggesting that much of what looks like an “oil shock recession” in the historical record is actually a “policy reaction recession.” The Fed sees general prices evolving, tightening excessively and pushes the economy into a recession that the oil shock alone would not have caused.
Conditions to overcome the peak are currently favorable. The 5-year/5-year forward inflation breakeven point is near the lower end of its historical range – exactly the environment of anchored expectations that Bernanke identified as giving the Fed room for patience. Iranian missiles and rising oil prices will not be enough to damage the American economy.
But a monetary policy error can shorten the distance between a fright and a shock considerably – and this risk exists in all scenarios on the board.
