Jerome Powell said it plainly in March: if inflation does not show further progress, rate cuts will not come. Five weeks later, oil prices have made that warning look prophetic.
Brent crude has surged more than 40 percent since the U.S. and Israeli strikes on Iranian government infrastructure began in late April. The immediate consequence was a partial closure of the Strait of Hormuz — the world’s most critical oil chokepoint, carrying roughly 21 million barrels per day. Tankers have rerouted around the Cape of Good Hope, adding weeks to delivery times and millions to freight costs. Energy markets, already fragile from two years of cautious Fed policy, are absorbing the shock with visible difficulty.
The Fed’s Impossible Math
The Federal Reserve entered 2026 with its sights set on a gradual easing cycle — two or three cuts priced in by markets, with the Committee cautiously optimistic that inflation had been sufficiently contained. That thesis has unravelled with striking speed. The CME FedWatch Tool now assigns a 74 percent probability that the federal funds rate remains anchored at its current 3.5 to 3.75 percent band through at least December 2026. Back in January, that outcome carried just 5 percent odds.
Chicago Fed President Austan Goolsbee articulated what many on the FOMC are quietly acknowledging: the central bank can envision a scenario in which it raises rates if the Iran conflict pushes inflation materially beyond control. That is not idle speculation — it is a direct acknowledgement that the transitory inflation narrative of 2021 has permanently shifted the Fed’s risk calculus toward fighting price growth rather than protecting employment.
Deutsche Bank’s macro strategy team reinforced that reading in a client note circulated this week, drawing a direct parallel to the 1979 oil crisis. In that episode, the Fed initially hesitated before undertaking its most aggressive tightening cycle in a generation. Deutsche’s Henry Allen wrote that central banks tend to correct for “the perceived errors of the last crisis” — and in 2026, that means refusing to be caught underestimating an inflation spike the way they were in 2021 and 2022.
“A key lesson from those past crises is that central banks correct for the perceived errors of the last crisis… as we face another inflation shock, central banks want to avoid the criticisms of 2022 that they’re too relaxed about inflation, and we can see how that’s informing the response today, with more hawkish rhetoric for a given level of inflation.”
— Henry Allen, Macro Strategist, Deutsche Bank
Oil Markets in Repricing Mode
Brent crude’s trajectory since late April has been steep and consistent. Trading around $68 per barrel before the strikes, the contract crossed $94 in the first week of May before easing slightly on reports of productive U.S.-Iran talks initiated by President Trump. Even with that partial de-escalation signal, Brent remains elevated — and the structural reality has not changed. The Strait of Hormuz is not fully open. Tanker insurance premiums have spiked. Shippers are pricing in a genuine supply disruption, not a temporary geopolitical event.
Goldman Sachs’s commodities research desk estimates that the rerouting of roughly 15 million barrels per day of crude and product shipments around the Cape has added between $4 and $7 per barrel to landed costs across Asian and European markets. That is not a rounding error for economies still absorbing the cumulative inflation of the past four years.
U.S. retail gasoline prices have climbed from a national average of $3.18 per gallon in mid-April to $4.72 by mid-May — a 48 percent increase in four weeks. That figure feeds directly into the PCE price index, the Fed’s preferred inflation gauge, with a lag of approximately three to five weeks. The Committee will begin seeing that data hit in its June and July deliberations.
What Comes Next: Scenarios for the Second Half of 2026
The base case, as priced by markets, is a Fed on hold through year-end. No cuts, no hikes — just a vigilant wait-and-see posture as the Committee parses incoming inflation and jobs data through a fog of geopolitical uncertainty. Morgan Stanley’s rate strategists align with this view, arguing that the Fed’s preferred approach remains data-dependence and that any oil-driven inflation impulse will need at least two months of sustained readings above 3.5 percent before triggering a formal reaction.
The upside risk — a risk markets have dramatically repriced since March — is a rate hike. If the Strait of Hormuz remains materially disrupted through Q3, and U.S. CPI re-accelerates above 4 percent on energy and shipping costs, the Fed’s June Summary of Economic Projections would almost certainly show the median dot migrating toward a hike. That would be the most significant policy reversal since the 1994-1995 tightening cycle, and it would arrive at a moment when credit markets are already pricing in elevated default risk for leveraged corporates.
A third scenario — ceasefire and normalization — remains plausible but increasingly discounted. The Iran situation has produced diplomatic openings before, and Trump administration officials have confirmed ongoing back-channel discussions. If a credible de-escalation framework emerges before June, the rate-hike tail risk fades rapidly and the current market pricing for a hold becomes accurate. But for now, the Strait stays closed, oil stays expensive, and the Fed’s room to manoeuvre stays uncomfortably narrow.
Markets: From Rate-Cut Euphoria to Hike Pricing
The reversal in rate expectations has not been orderly. High-duration assets — growth stocks, tech equities, and long-duration Treasuries — have all registered sharp losses since the Iran strikes. The S&P 500’s technology sector, which had led the year-to-date rally on artificial intelligence enthusiasm and the assumption of cheap money ahead, is down approximately 9 percent from its April peak. The Nasdaq has underperformed by an even wider margin.
Bond markets tell the story with particular clarity. The 10-year U.S. Treasury yield climbed from 4.12 percent in late April to 4.78 percent by mid-May — a move that reflects both the inflation re-pricing and the implicit threat to Federal Reserve credibility that a supply-driven shock poses. The yield curve, which had been re-steepening on hopes of easing, has inverted again — a signal that credit markets are assigning meaningful probability to a policy error.
The Federal Reserve has managed inflation expectations carefully since 2022. Chair Powell’s credibility has been hard-won and is not lightly sacrificed. But the fundamental problem the Committee faces in mid-2026 is not one of communication — it is one of arithmetic. Oil prices at elevated levels feed through to consumer prices with near-mechanical certainty. Waiting for confirmation of an inflation trend means acting after the trend has already established itself. And the lessons the Fed has explicitly drawn from 2021-2022 suggest that when the arithmetic conflicts with the politics, the arithmetic wins.
Markets are right to be cautious. The next data point — whether it comes from the May CPI print, the June jobs report, or another Hormuz-related headline — will determine whether the Fed’s 2026 story ends with a held rate, a single hike, or something more disruptive. For now, all three are live possibilities.
