Do higher oil prices mean higher inflation?

The onset of the Iran war on February 28th created an oil supply shock as approximately one-fifth of the world’s oil production flows through the Strait of Hormuz which has effectively been shuttered since the start of the war. High oil prices have a negative impact on the economy, as they reduce discretionary consumer spending by increasing the cost of most goods. The impact of more expensive oil on the economy is immediate - we all feel it through higher gasoline prices. Oil is a globally traded commodity which means what happens on the other side of the world has an immediate impact on gasoline prices in North America. The Iran war has been a stark reminder that not only is the world’s economy still dependent on oil, but the supply chain for oil is also very tight without much room for disruptions or outages. Despite the exponential growth in renewable energy (solar & wind) both in Alberta and globally, the world remains dependent on oil predominantly to produce transportation fuels and petrochemicals (fertilizers, plastics, etc.).

There’s a significant difference between a long-term (permanent) or short-term (temporary) supply shock in economics. The market continues to view the Iran war and subsequent increase in oil prices as a temporary supply shock which is highlighted in this week’s chart. The chart shows the market’s expectation for U.S. inflation (CPI) next year in black and the following year in red. Notice expectations for CPI in 2028 (2.4%) are significantly lower relative to 2027 at 3.3%. In other words, the market expects higher oil prices to be short-lived. If the market believed higher oil prices were here to stay, we wouldn’t see a substantial decrease in the expectation for CPI in 2028.

Obviously, market expectations can be wrong, however, the alternative (Strait of Hormuz remaining shut), is so impractical that the market is discounting the probability of that outcome near zero. If the Strait of Hormuz remains shut for a prolonged period, oil prices would likely move above $200 per barrel as they would need to reach a level which would force the world to use ~20% less oil. Oil demand is elastic (price impacts demand); however, oil has become less elastic over time as the current economy is much less dependent on oil than it was in the past due to growth in renewable energy and improvements in fuel efficiency. Oil prices approaching $200 would crush the U.S. consumer and the global economy. This is why previous U.S. administrations have been reticent to attack Iran and attempt regime change – Iran’s retaliation was always going to be accomplished via the Strait of Hormuz – economic retaliation because they can’t defeat the U.S. militarily. This is why President Trump has shifted his tone towards negotiating a settlement with Iran – the longer the Strait remains closed, the higher the probability the Republican Party loses control of both the House and Senate in November.