The war between Iran and Israel increases the risk of inflation. The Federal Reserve is closely monitoring the situation

The escalation in the Middle East is pushing up oil markets and inflation expectations, making the Federal Reserve's balancing act between price stability and full employment more difficult, especially as officials prepare for next week's meeting.

Uncertainty about tariffs has already kept Fed policymakers on the sidelines on rate decisions, and now the volatility in the oil market is likely to make them more cautious.

Crude prices soared after Israel launched a military operation against Iranian nuclear facilities and military targets, and Iran immediately launched a drone and missile strike, raising concerns about more conflict. Oil prices initially rose more than 13% on the news, and while they have since retreated, analysts believe prices could remain elevated for some time.

"Rising geopolitical uncertainty means energy markets must price in higher risk premiums for potential supply disruptions," ING analysts wrote in a note on Friday. They warned that Brent crude could surge to $120 a barrel if shipping in the Strait of Hormuz, a choke point for nearly a third of global oil trade, is disrupted. Currently, Brent is trading just under $75 a barrel.

Even in a milder scenario, higher energy prices could keep inflation elevated for longer and force the Federal Reserve to keep interest rates high. "A surge in oil prices has the potential to disrupt the current narrative about U.S. inflation, which has been milder than expected despite tariffs," ING analysts wrote. They said that while inflation in commodity prices is relatively muted for now, "we expect to see a more substantial uptick in monthly inflation data throughout the summer."

Those concerns are already reflected in market volatility. "If this situation does not ease soon, it will certainly have some impact on the inflation data," Louis Navellier, founder of Navellier & Associates, wrote on Friday. The Treasury market "seems to be responding more to the threat of inflation than to the possibility of World War III," he said.

Both the 2-year and 10-year Treasury yields rose on Friday.

Surging energy costs threaten to raise investor and public expectations for near-term inflation, creating a potentially self-reinforcing dynamic that could force the Fed to act.

"The main risk to the rate outlook is that inflation expectations become unanchored. If consumers push near-term inflation expectations higher, the Fed will almost certainly delay the idea of ​​a rate cut until December at the earliest, or even into next year," RSM Chief Economist Joe Brusuelas wrote in a report.

Federal Reserve officials are expected to keep interest rates unchanged throughout the summer. The latest geopolitical developments may further reinforce this view. However, Brusuelas warned that the combination of "tariffs and oil-induced price shocks" could prompt a policy shift that would further delay the Fed's rate cuts or even raise them.

For now, the Fed seems more inclined to sit on the sidelines and wait and see. "Given the new tariffs and rising energy prices, the Fed should wait and see for now and not take any action until the current volatility passes," Brusuelas said.

According to the CME FedWatch tool, the market currently expects two rate cuts totaling 0.5 percentage points by the end of 2025.

The Fed's next meeting will be held on June 17-18, and the market generally expects this to be the fourth consecutive time that interest rates will remain unchanged.