The chances of accelerating U.S. inflation are growing with each passing day as the war in the Middle East grinds on.

The average price of gasoline nationwide spiked to almost $4 a gallon as of Thursday. But there’s something besides rising prices American consumers and investors should feel nervous about: the prospect of deflation.

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A scenario in which rising oil prices hit consumers so hard that the shock pushes the economy into a recession is what some traders in one part of the financial market are currently envisioning. When accompanied by a vicious cycle of falling prices and falling demand, that turns into a process known as deflation. And that outcome might be even worse than inflation because the Federal Reserve is greatly limited in what can do in response.

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In other words, the U.S.-Israeli war against Iran is more likely to create what could be only bad economic outcomes the longer it drags on.

That’s the sense gained when looking at a key indicator of the market’s expectations for average annual inflation five to 10 years in the future. The chart below shows the “five-year, five-year inflation swaps” rate. It has largely fallen since the military conflict began on Feb. 28. This comes despite a huge spike in oil prices, which acts as a tax on consumers.

The swap rate was near 2.4% on Thursday, down from more than 2.5% in January and from almost 2.55% last summer, according to Bloomberg data. As a whole, the chart reflects what looks like a relatively stable inflation outlook.

However, some traders are more focused on the direction of the rate: It’s largely down, even though futures prices for Brent crude BRN00, the global oil benchmark, went back above $100 a barrel. That could spell trouble ahead.

“Instead of a structurally higher inflation environment that we are going to head into, the market is much more worried that an initial energy shock will bring about weaker economic growth and possibly deflation,” said Gang Hu, an inflation trader at New York hedge fund WinShore Capital Partners. “If I were to be a betting man, I would say I agree with that, actually.

“An oil shock could easily be near-term inflationary and long-term deflationary,” Hu said in a phone interview. “The longer the war stays, the more of a hit it will be to the economy,” which could already be weakening. Every day that gas prices stay at current levels, consumers are spending less of their discretionary income on other things, he added.

Worries about accelerating inflation gripped financial markets again on Thursday, as the Iran war approached the one-month mark. Stocks DJIA SPX COMP finished lower, while yields on 2-year BX:TMUBMUSD02Y and 10-year government maturities BX:TMUBMUSD10Y respectively spiked to 3.98% and almost 4.42% — the highest 3 p.m. Eastern time levels since last June and July. That’s already pushed up borrowing costs, including on new mortgage loans. Meanwhile, fed-funds futures traders priced in a 46.5% likelihood of a Fed rate hike by December, up from 20.2% on Wednesday.

Deflation often has been associated with Japan, which experienced stagnant or falling prices from the 1990s through 2022. The last time the U.S. experienced a period of falling prices was March-October 2009, around the time of the recession fueled by the bursting of the U.S. housing bubble. That recession, which lasted from December 2007 through June 2009, led to a drop in consumer demand and period of declining prices.

“Everyone will have their own views on inflation and deflation, but I don’t think it will be a one-way street,” said Hu of WinShore Capital. “What we can be certain about is that the volatility of inflation will go up. It will be very hard for inflation to stay at 2%” — which is the Fed’s target — “but we could easily see 3% or 1% inflation.”

One consequence of that backdrop is that yields on short-dated government debt, like the 2-year Treasury note, will be “extremely volatile,” Hu said. He added that it’s less clear how long-dated Treasurys and stocks may react, “but in general, this should generate more volatility in financial-market assets.”

Hu has a track record of being right when it comes to the path of U.S. price gains. In July 2022, when data showed that the consumer-price index’s annual headline rate jumped to 9.1% for the previous month, he warned that “inflation is going to be stickier than most people imagine.” And in February 2023, he said inflation could easily take more than a year to decline by enough for the Fed to cut rates. The central bank did not start cutting rates until September 2024.

Not everyone is on board with his deflation view, however. “I’d still be in the camp of saying this is unlikely, because we’d still need some evidence of it somewhere,” said Brian Mulberry, senior client portfolio manager at Chicago-based Zacks Investment Management. “We certainly expect higher energy prices will have some impact, but it may not get to the point of worry about consumers spending significantly less than they have been.”

Gary Schlossberg, a global strategist at Wells Fargo Investment Institute in San Francisco, said that while a deflationary outcome “is certainly possible, it is not our base case.”

“We still view that sort of chain of events as something that could be mitigated by some positive developments out there,” Schlossberg said. “And we look for that scenario to be less likely than an early end to the war and a decline in fuel prices beyond the next month or two.”

At Goldman Sachs, commodities strategists expect Brent oil prices to average $105 a barrel in March and reach $115 next month before declining to $80 in the final three months of this year. They estimate that these prices could peak at $140-$160 under adverse scenarios.

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