As the conflict in the Middle East escalates, the Federal Open Market Committee (FOMC) faces one of the most difficult dilemmas in recent years. The decision, which we will learn on Wednesday evening, will not be just a routine move in the monetary cycle, but a response to the rapidly changing geopolitical and economic reality.
Most analysts and economists are almost 100% confident (99% certain) that the Fed will keep interest rates unchanged at today's meeting. After a series of three autumn cuts, the federal funds rate should remain in the range of 3.50-4.75%. Although until recently there was speculation about possible increases due to persistent inflation (3.1%), the weakening labor market prevented bankers from making such a hawkish move.
Energy shock and “unanchoring” of expectations
The key game-changing factor is the energy market situation. The war in the Middle East and the almost complete blockade of the Strait of Hormuz have caused a price shock that directly affects the American consumer.
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Allianz Trade experts predict that the increase in energy prices will cause inflation in the USA to jump to +3.6% y/y in April and May 2026. They also assume that oil prices will remain at an average level of approximately USD 90 per barrel in the second quarterwhich will dramatically increase the energy CPI – from just +0.4% in February to a forecast +15% in April.
However, the Fed's biggest concern now is the loss of control over inflation expectations. If the bank is deemed too lenient in the face of the oil shock, inflation could remain high for longer.
Labor market – a weakness that the Fed cannot save now
The situation in the American economy is becoming schizophrenic. On the one hand, we have price pressure, on the other hand, there are clear signals of a slowdown in the labor market. In February, the number of non-farm payrolls decreased by 92,000, and the private sector (excluding health care) continues to reduce jobs. Nevertheless, Allianz Trade analysts emphasize that with inflation exceeding the 2% target for five years, the Fed cannot afford to save the labor market at the expense of price stability.
When will we see discounts?
The “higher rates for longer” scenario becomes the baseline. “Even in February, the futures market was pricing in another Fed rate cut for June, now it gives just over 50 percent chance that such a decision will be made in September or October. Even one 25-point reduction is not fully discounted by the end of the year” – comments Krzysztof Kolany in “PB”.
The Fed will not consider rate increases at this point, but the expected rate cuts are well underway. A strong increase in the prices of energy raw materials does not translate into growth in the US, because on the one hand it affects consumer demand, but on the other hand the US is a net exporter of energy. However, the impact on prices is obvious. Therefore, for the central bank, the direction of change is indisputable – relatively higher interest rates – says Dr. Przemysław Kwiecień, CFA, Chief Economist of XTB.
“We have long assumed that the Fed's ability to cut interest rates in 2026 would be limited, and prior to the outbreak of conflict in the Middle East, we expected only one rate cut in June – which was a much more hawkish stance than what financial markets are currently considering. We at Allianz Trade currently expect that The Fed will wait until September, when inflation should begin to decline, although it will still remain above target” we read in the Alianz Trade report “Warsh's double dilemma: as the Middle East rewrites the Fed's action scenario.”
“The labor market is likely to remain weak and even weaken further over the summer as higher inflation eats into household incomes and the profit margins of some businesses. If the Fed refrains from making decisions in the near future (keeps rates unchanged), the risk of second-round effects in prices that would intensify the initial price shock on the energy market may be lower than in 2022“- he adds.
However, monetary policy does not have to be one-way. Yesterday, the Reserve Bank of Australia decided to increase interest rates for the second time in a row. This is the first Western central bank to tighten monetary policy this cycle. The problem for Australians before the war with Iran was excessive and persistent inflation. The RBA is going against the global trend. Western central banks have been lowering (or at least lowering) interest rates for two years, moving from a moderately restrictive to a moderately expansionary policy.
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Warsh is seen as a dove on interest rates (believing current policy too restrictive for small businesses), but an extreme hawk on the Fed's balance sheet. His demands for a drastic balance sheet reduction could trigger a deleveraging spiral in the financial system, which since the 2008 crisis has relied on abundant reserves provided by the central bank.
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The next Fed meeting will most likely maintain the current rates, but the announcement regarding the future will be crucial. The war in the Middle East is “rewriting” the script of the Fed's actions, forcing it to maintain a restrictive stance in the face of an energy inflation shock, even at the cost of further weakening the labor market and increasing the risk to financial stability.
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