How a Geopolitical Oil Shock in Iran Could Reshape U.S. Inflation and Fed Policy

By  Achilles Tsirgis

Recent tensions in the Middle East have escalated dramatically after the United States carried out airstrikes on Iranian nuclear sites. In response, Iran has threatened to shut down the Strait of Hormuz, a key shipping lane for roughly 20% of the world’s oil supply, and halt its own oil production entirely. These developments have rattled global markets and led analysts to warn of a potential energy shock.

The crisis has renewed fears about a sharp rise in global oil prices, which could reignite inflationary pressures in the U.S. and complicate the Federal Reserve’s path forward on interest rates, particularly amidst the ongoing uncertainty regarding tariffs & potential trade wars. But how much would such a shock actually impact inflation and monetary policy? We built an economic model using monthly data from 1986 to 2023 to estimate the shock.

Methodology: a Vector Autoregression Model

To analyze the potential impact of an oil shock on the U.S. economy, we employed a Vector Autoregression (VAR) model. This statistical method estimates how a disturbance in one variable, such as oil prices, influences other variables, including inflation and interest rates, over time.

The data utilized in our analysis includes the following:

1. Oil Price: Monthly average of West Texas Intermediate (WTI) crude

2. Inflation: Monthly average of the U.S. CPI inflation rate

3. Interest Rate: Monthly average of the Federal Funds Effective Rate

We utilized data from 1986 to 2023 to create scenarios reflecting inflation transmission in an environment of inflation targeting. Hence, data covering the high-inflationary periods of the oil crises before 1986 were excluded, although their inclusion as a robustness check unsurprisngly reinforces our model. The dates were all transformed into time series format using Stata, and seasonality was checked. We chose the optimal number of lags based on model fit testing accordingly. Based on the Akaike Information Criterion (AIC) and Schwarz Bayesian Information Criterion (SBIC), a lag length of 2 was selected as optimal.

We estimated the VAR using an Orthogonalized Impulse Response Function (OIRF), which predicts how each variable reacts over time to a one-time, 1-standard-deviation (SD) shock in oil prices. The model consists of a response (what we are measuring) and an impulse variable (the variable receiving the one-time shock) . In the example of model_2_irf d_inflation d_interest, the interpretation is as follows: “What is the expected response of inflation to a one-time, one-standard-deviation shock in the interest rate?”. Values appear to "dip" to zero in month 1 because the model, with a lag structure of 2, assumes the transmission effect from the shock does not materialize until month 2:

Findings:

We have determined that a 1 Standard Deviation (SD) fluctuation in oil prices corresponds to:

An immediate effect (from t to t+1) equal to:

• An increase in oil prices by approximately 4.63 units

• An increase in inflation (Δ inflation) by about 0.34 percentage points, with a 95% confidence interval of 0.29 to 0.39, suggesting a statistically significant increase in consumer prices.

• Interest rates increase by roughly 0.036 points (from the Federal Funds Rate), with a tight confidence range of 0.019 to 0.053, reflecting modest market anticipation of tighter monetary policy

  
  

The following Short-Term Dynamics in months 1 to month 6 (non-cumulative at this stage):

• At month 2, inflation remains elevated by about 0.14 percentage points, and interest rates increase by 0.021 points, indicating the inflationary shock persists briefly before fading.

• By month 4, inflation’s additional effect moderates to 0.025 points, with interest rates responding at about 0.011 points.

• By month 6, both inflation and interest rates begin to normalize, with effects around 0.001 to 0.004 points, statistically near zero.

Interpretation:

This trajectory mirrors classic supply-side oil shocks, such as the 1973 Oil Crisis, the 1979 Iranian Revolution or the 1990 Gulf War, which led to short-term price spikes and inflation surges, followed by gradual policy tightening. The inflationary response is immediate and economically meaningful, while monetary policy (proxied by the interest rate) lags slightly but responds proportionately.

Based on this effect we then constructed 4 different scenarios for cumulative effects of inflation response, assessing each of the 4 scenarios under the assumption of linear effects, which is also the identifying assumption of VAR modelling. The shocks correspond to the impact of a one-time (immediate) increase and not to a cumulative increase in oil prices:

Possible Scenario	Standard Deviation (SD) Shock	Approx. Oil-Price Jump
Minor Disruption: Iran announces limited export cuts (e.g., a few key fields), but other OPEC members largely maintain output. Markets react, but price rise is modest.	0.5 SD	≈ 2.3 $/barrel
Strait of Hormuz Warning: Iran threatens to close the Strait, triggering flight-to-safety buying; or a short-lived U.S. strike temporarily sidelines some Iranian production.	1 SD	≈ 4.6 $/barrel
Partial Shutdown: Iran halts most exports; OPEC members partly but not fully compensate. Significant global supply squeeze, akin to mid-1970s embargoes.	3 SD	≈ 13.9 $/ barrel
Full Production Cut + Non-Offset: Iran stops all exports and other OPEC producers either can’t or won’t make up the loss, reminiscent of 1973 embargo severity or a major geopolitical war.	6 SD	≈ 27.8 $/barrel

Finally, for each scenario we calculated the cumulative inflation response to the oil-price shocks. These are noted as an increase in inflation, but in reality they should be thought more in terms of the inflationary pressures that the central bank (Fed) would have to fight with its arsenal. A graph serves well to show the different effects of each scenario:

Line graph showing inflation response to oil-price shocks over 8 months. Four scenarios: minor disruption, closure compensated by OPEC and domestic productions, shutdowns, and full cut. The model assumes linear scaling between different scenarios, which is an identifying assumption of VAR scenario modelling.

Implications for Monetary Policy & Markets:

Oil price shocks have historically had profound effects on both inflation and economic activity. Even moderate oil shocks now carry more weight due to sticky services inflation and global supply fragility. As the Fed balances inflation risks against a slowing economy, geopolitical oil shocks, including Iran, could quickly reshape the outlook for rates, inflation, and recession risk.

Using a baseline Aggregate Supply-Aggregate Demand (AS-AD) framework, we can assess how varying magnitudes of oil shocks, represented here as standard deviation (SD) changes in oil prices, may influence inflation, interest rates, and financial markets, especially the bond market.

Scenario 1: 0.5 SD Shock (≈ $2-3 increase in oil prices)

This represents a mild supply disruption, perhaps due to limited geopolitical tensions or a short-term outage in oil exports. The shock nudges the short-run aggregate supply (SRAS) curve leftward only slightly, reflecting marginal increases in input costs. Aggregate demand (AD) remains largely unchanged. The result is a small, temporary increase in inflation that remains well within the Federal Reserve’s comfort zone. Monetary policy is unlikely to shift in response. Interest rates would remain stable, and the bond market may even rally slightly, as investors seek safe assets amid modest geopolitical uncertainty.

Plausibility: This is highly plausible. Oil markets are frequently subject to small frictions, and a 0.5 SD move falls well within the bounds of typical monthly price fluctuations.

Scenario 2: Strait of Hormuz Closure - 1 SD Shock (≈ $4.6 increase)

A 1 SD oil price increase might correspond to a significant disruption, such as Iran halting exports or more aggressive enforcement of oil sanctions. The SRAS shift is now more noticeable, driving inflation up over several months. Real output begins to soften. If consumers and businesses anticipate sustained energy price pressure, AD could also slow slightly. The Federal Reserve would become cautious under these conditions, likely pausing any planned rate cuts. In the bond market, yields on longer-term bonds could fall as investors anticipate weaker growth, while shorter-term yields might hold firm. Breakeven inflation rates would likely rise.

Plausibility: This scenario is moderately likely. While not routine, events like these occur every few years, especially in the context of tense U.S.-Iran relations.

Scenario 3: Partial Shutdown - 3 SD Shock (≈ $14 increase)

This level of shock suggests a major geopolitical event such as a full closure of the Strait of Hormuz or coordinated production restraint by OPEC+. The SRAS curve shifts sharply to the left, creating clear stagflationary pressure, meaning higher prices combined with weakening output. Inflation could increase by over a percentage point, putting the Fed in a difficult position. Although economic momentum is weakening, the central bank may be forced to hold or even raise rates to prevent inflation expectations from becoming unanchored. In bond markets, volatility would rise. Yields may initially spike due to inflation fears, then decline as recession expectations build. Inflation-linked bonds would likely outperform nominal Treasuries.

Plausibility: This is a tail-risk scenario. A closure of the Strait would cut off nearly 20% of global oil supply flows. Plausible in a major conflict, but historically rare.

Scenario 4: Full Production Cut and No Offset of Production - 6 SD Shock (≈ $28 increase)

A 6 SD shock signifies a full-blown geopolitical crisis, possibly involving regional conflict, embargoes, or the long-term disruption of global oil supplies. This results in a massive SRAS contraction and, likely, a simultaneous contraction in AD due to heightened uncertainty and loss of consumer confidence. The U.S. economy enters a textbook stagflationary environment: sharply rising inflation coupled with declining output. Inflation could surge by more than 2.5 percentage points. The Federal Reserve’s credibility becomes paramount, and the central bank may be compelled to raise interest rates despite deepening economic distress. Bond markets would experience severe volatility. Real yields could fall as flight-to-safety flows dominate, while inflation expectations push break-evens higher. Inflation-protected securities (like TIPS) would likely be in strong demand.

Plausibility: This is unlikely but not impossible. It would likely require multiple simultaneous shocks: e.g., a large-scale war in the Gulf, prolonged OPEC non-cooperation, inability of US to increase production through fracking, and a breakdown of energy logistics. In this setting it acts more as a stress-test than a central-case scenario, but as history shows it is not impossible.

Conclusion and caveats:

The recent escalation in the Middle East has reawakened concerns about global oil supply vulnerabilities and their downstream effects on inflation, monetary policy, and financial markets. By modeling a range of potential oil price shocks our model primarily aims to demonstrate that inflationary pressures can emerge quickly and with meaningful macroeconomic consequences. Even moderate shocks, such as a 1 SD or ~$4.6/barrel rise, can raise inflation expectations and prompt a more cautious stance from the Federal Reserve.

Our findings suggest that the U.S. economy remains exposed to energy-driven supply shocks, particularly in a macroeconomic context already shaped by sticky core inflation and reduced slack in the economy. Within a standard Aggregate Supply-Aggregate Demand (AS-AD) framework, oil shocks operate primarily through supply-side channels, pushing inflation higher while slowing output growth. This stagflationary tradeoff has traditionally persisted as a genuine challenge for monetary authorities seeking to balance price stability with growth, and could mount up to the existing pressures of tariffs and a potential trade war.

That said, there are important caveats. First, the most extreme scenarios require a convergence of multiple geopolitical disruptions. Second, global energy markets have evolved since earlier oil crises. The growth of U.S. shale production (fracking), greater strategic reserves, and more diversified energy supply chains offer some insulation against the worst-case outcomes. In a sustained crisis, American producers could ramp up output and partially offset global shortages, potentially capping long-run price spikes. Moreover, this cumulative model is a static framework that assumes no structural changes over time, treating each monthly period as identical in its response dynamics; this might be a particular concern if the structural framework changes specifically due to the crisis. Finally, the response of inflation and interest rates depends not only on the size of the shock but also on public expectations, policy credibility, and the broader macroeconomic context. Markets may price in geopolitical risks quickly, but monetary policy operates with lags and under uncertainty.

In sum, while not all scenarios modeled here are equally likely, they emphasize the sensitivity of inflation and financial conditions to oil supply shocks. As geopolitical risks persist, especially in energy-critical regions, policymakers and investors alike should remain attentive to tail events even if their statistical probability seems low.

You can find the .do file and the data we used here.