In a significant shift, investors who had been anticipating two or three interest rate cuts within the year are now reassessing their expectations, with many believing that not even one cut might occur. The latest data from the CME Fedwatch tool indicates a striking 74% probability that the federal funds rate will remain unchanged at its current range of 3.5% to 3.75% by the December 2026 meeting. This marks a dramatic change from January, when the odds of such an outcome were just 5%, and there was a prevailing expectation of at least a 50% chance for two or three cuts.
The primary catalyst behind this revised outlook has been the recent surge in oil prices. Following the initial military actions by the US and Israel against Iranian government officials and military infrastructure, Iran responded by effectively closing the Strait of Hormuz, a crucial chokepoint for global oil transport. This disruption has led to a significant spike in oil prices, notably a over 40% increase since the onset of the conflict. While Brent crude prices saw a slight decline on Monday amid indications of possible de-escalation from President Trump, the rise has led to higher gas prices and reignited concerns about escalated inflation.
This anxiety around inflation is prompting the Federal Reserve to adopt a more hawkish stance in its monetary policy considerations. Chicago Fed President Austan Goolsbee hinted at this shift on Monday during an interview with CNBC, stating that the Fed might consider hiking interest rates depending on how the Iranian conflict evolves and the trajectory of inflation.
The initial optimism among investors regarding potential rate cuts stemmed from a perceived dovish pivot by the Fed, sparked by cooling inflation trends. Lower interest rates are a cornerstone of bullish projections put forth by leading Wall Street analysts, making the current uncertainty regarding rate cuts an unsettling development.
Adding complexity to the situation, analysts at Deutsche Bank have provided insights that suggest a historical context could influence the Fed’s decision-making process. The bank’s note emphasized that the Fed is likely to heed lessons from previous crises, notably the aggressive rate hikes during the 1979 oil crisis, which occurred in the face of rampant inflation. Past mistakes, such as the overly accommodating response to the COVID-19 pandemic following the 2008 financial crisis, could prompt the Fed to adopt a more cautious approach now. Macro strategist Henry Allen articulated that central banks are inclined to learn from the perceived errors of their predecessors, seeking to avoid criticism for being too lenient in addressing inflation.
During the recent Federal Open Market Committee meeting, Fed Chair Jerome Powell reiterated the committee’s commitment to monitoring the effects of the ongoing Iran conflict on inflation indicators. He stated that absent progress on inflation, interest rate cuts would not be forthcoming.
While President Trump recently alluded to “productive” discussions between the US and Iran regarding an end to hostilities, the immediate future remains uncertain. With the Strait of Hormuz remaining closed and expectations for interest rate cuts dwindling, market participants are left to navigate this evolving economic landscape with caution.
