"Stagflation Storm" Approaching: Federal Reserve Rate Cuts May Be Off the Table, and the Rate Hike Nightmare Is Quietly Emerging

How the Middle East Conflict Reshapes the Federal Reserve’s Interest Rate Decisions?

Southern Finance 21st Century Economic Report journalist Wu Bin reports

Under the shadow of gunfire in the Middle East, the Federal Reserve finds itself once again in an awkward position. According to CCTV News, the Federal Open Market Committee announced on March 18 that it would maintain the target range for the federal funds rate at 3.5% to 3.75%. This decision aligns with market expectations.

The closely watched “dot plot” indicates that members generally expect one rate cut this year, with another possible cut in 2027, though the specific timing remains unclear.

Meanwhile, the market anticipates about a 60% probability that the Fed will not cut rates or will raise rates once this year. The CME FedWatch Tool shows that the most likely scenario is no rate cut this year, with a probability of 56.1%, and there is even a 3.6% chance of a rate hike this year.

However, it is important to note that support for not cutting rates this year is also increasing. Under inflationary pressure, seven out of the 19 FOMC members predict that there will be no rate cuts this year, an increase of one from the December forecast.

In a corresponding statement, Fed Chair Jerome Powell said at the press conference following the rate decision that short-term increases in energy prices will push overall inflation higher, but the scope and duration of the related impacts remain highly uncertain. If there is no progress on inflation, there will be no rate cuts. He emphasized that monetary policy does not have a preset path and will be decided based on economic data at each meeting.

The situation is further complicated as inflationary pressures resurface, while the U.S. labor market is also slowing down, and the risk of recession is suddenly rising. In the face of stagflation risks, the path ahead for the Federal Reserve is fraught with challenges.

Due to the U.S.-Iran conflict, the risk of a recession in the U.S. is increasing; if the conflict persists for an extended period, the U.S. may fall into “stagflation.”

Lu Zhe, chief economist at Dongwu Securities, analyzed for the 21st Century Economic Report that the soaring inflation in the U.S. and the risk of stagflation depend on the situation in the Middle East and oil price trends. In a baseline scenario, the impact of oil prices on inflation is often temporary, and inflation will cool down as oil prices retreat. If the U.S.-Iran conflict rapidly eases in the coming weeks and oil prices return to the previous central level of $65 per barrel, then the increase in oil prices will only affect the March U.S. CPI, without substantial impact on the FOMC decisions in March and April or on the U.S. growth outlook.

In a cautiously optimistic scenario, Lu Zhe expects the U.S.-Iran conflict to ease in the first half of the year, but the uncertainty of geopolitical conflicts raises systemic pressure on international oil prices. Calculations show that if crude oil prices remain around $80-$100 per barrel throughout the year, the U.S. CPI year-on-year will rebound to between 2.7%-3.2% in March to May, and the December CPI year-on-year will be between 3.0%-3.5%. This inflation path within the year suggests that the Fed may not have further rate cut space this year. Given that the current U.S. economy is facing a cyclical trend of overall demand cooling and a structural deepening of the “K-shaped” economy, without further monetary policy easing, it may lead to a stagflation situation of “growth below 2% + inflation above 3%.”

In a more pessimistic risk scenario, Lu Zhe warns that if the U.S.-Iran conflict escalates and drags on, with the Strait of Hormuz remaining blocked and global crude oil supply continuing to be scarce, then oil prices could reach a second peak and maintain high levels. In an extreme case, if the U.S. sends ground troops, the U.S.-Iran situation could inevitably fall into a prolonged war. The impact on oil prices in this scenario would far exceed that of the 2022 Russia-Ukraine conflict, with prices climbing and maintaining a high level of $120-$150 per barrel, potentially leading U.S. CPI to rise year-on-year above 7% by the end of 2026, thus bringing about a second wave of inflation; for the Federal Reserve, not only would further rate cuts be impossible, but it may also need to resume rate hikes to curb high inflation, leading the U.S. economy toward a “Great Stagflation” scenario similar to that of the 1970s.

Although the current U.S. economic growth is clearly cooling, the labor market is weakening rapidly, and inflation levels remain stable, Chief Economist Cheng Shi of Industrial Bank International reminds that the rising global geopolitical risks still pose higher economic uncertainty for the Federal Reserve. By maintaining the current interest rate level, the Fed can help consolidate the trend of falling inflation on one hand, while remaining vigilant against inflation fluctuations on the other. Additionally, it leaves space for the Fed to observe economic trends and assess future policy adjustments, maintaining a relative balance between controlling inflation and stabilizing the economy.

In fact, even before the outbreak of the conflict in the Middle East, inflationary pressures in the U.S. were already rising. According to CCTV News, on March 18, the U.S. Bureau of Labor Statistics released data showing that after seasonal adjustment, the PPI for February 2026 rose by 0.7% month-on-month and 3.4% year-on-year, exceeding expectations and marking the largest increase in a year.

Mike Medeiros, a macro strategist at Wellington Management, analyzed that Powell’s concern over the risks of rising inflation clearly outweighs those of declining inflation. In the past, the Federal Reserve typically overlooked the short-term inflation effects caused by high oil prices driven by supply-side factors, as they were often offset by weak demand. However, Powell specifically noted this time that inflation has exceeded the target for five consecutive years, acknowledged that inflation in the service sector is too high, and expressed concerns that the rise in short-term inflation expectations could translate into medium-term inflation expectations.

Additionally, Powell mentioned that improvements in productivity help to enhance real income, but the initial shock from artificial intelligence is more likely to manifest as upward pressure on inflation rather than suppressing it.

The Trump administration’s legal offensive against the Federal Reserve has already threatened its independence, as Congress has granted the Fed the power to independently set interest rate policies. Fed officials and many economists in the private sector believe that monetary policy-making free from political interference can lead to better economic outcomes.

At the press conference following the rate decision, Powell stated that if he has not been confirmed as the successor when his term as Fed Chair ends, he will continue to serve as “acting chair” until a successor is officially confirmed. He will not leave the Fed until the conclusion of the criminal investigation conducted by the U.S. Department of Justice.

Moreover, Powell hinted that even after the investigation concludes, he may continue to stay at the Fed. “I have not made that decision yet. I will make a decision based on what I believe to be in the best interest of the institution and the people we serve.” Powell’s term as a Fed governor will last until January 31, 2028.

Lu Zhe analyzed for reporters that Powell’s term officially expires on May 15, 2026, and there are currently two potential scenarios for him to remain. One is a temporary stay, which is a precedent-based institutional arrangement aimed at avoiding a leadership vacuum at the Fed. The other is a long-term stay as a governor; while Powell’s term as Fed Chair ends this May, his term as a Fed governor lasts until January 31, 2028. Legally, he can continue to serve on the committee as an ordinary governor after stepping down as chair. Since Marriner Eccles in 1948, no Fed Chair has chosen to remain as a governor after stepping down. If Powell does this, he will break an almost 80-year tradition aimed at blocking direct White House intervention in Fed decisions.

To avoid the aforementioned outcome, Trump has already launched an “attack” on Powell. The U.S. Department of Justice is investigating Powell on grounds of “exceeding the budget for the Fed’s headquarters renovation.” This approach is widely interpreted as political pressure aimed at forcing Powell to resign voluntarily. Recently, Powell sent a strong signal to the Trump administration through his lawyer: if the criminal investigation into his budget overruns continues, he will remain as a governor until 2028 after his chair term ends in May. Meanwhile, Trump’s plan also faces obstruction from the Senate, as Republicans have stated they will not approve a new chair nomination until there is a clear outcome and procedural fairness in the investigation against Powell. Therefore, Lu Zhe anticipates that Trump will ultimately face pressure to withdraw the lawsuit, avoiding the tail risk of Powell remaining as a governor, which would be a better outcome for both parties and for Fed decisions.

Overall, there is a significant divergence among Fed officials regarding the predicted interest rate path for the coming years, with the median showing that the Fed is expected to further cut rates in 2027, after which the federal funds rate will stabilize around a long-term level of approximately 3.1%.

Lu Zhe analyzed for reporters that the median forecast in the dot plot indicates one rate cut in 2026, unchanged from December last year. From the distribution, the expected number of rate cuts in 2026 is as follows: 0-1-2-3-4 cuts by 7-7-2-2-1 members, indicating that more members expect no rate cuts in 2026 compared to four members in the December dot plot. On the surface, the overall expected magnitude of rate cuts in 2026 has narrowed, but in the current context of escalating Middle Eastern tensions and soaring oil prices, market expectations for a rate cut by the Fed in 2026 have narrowed to less than once. Therefore, this dot plot is not as “hawkish” as expected; following the publication of the meeting statement and dot plot, market expectations for rate cuts throughout the year briefly rose from 80% to 93%. Additionally, out of the 19 members, 12 support at least one rate cut, indicating that Fed members still lean towards “moderate rate cuts.” However, amid the uncertainty of the Middle Eastern situation, there are significant variables in oil price trends and inflation trends, which also means that the reference value of the dot plot is relatively limited. At the March FOMC meeting, Powell also expressed this viewpoint.

Considering that the U.S. has strong energy self-sufficiency and low direct dependence on the Strait of Hormuz, the direct impact of this Middle Eastern conflict on U.S. energy supply is limited. Nevertheless, Cheng Shi reminds that geopolitical risks can still transmit to the U.S. economy through three main channels.

In terms of price transmission, since oil is a globally priced commodity, although the U.S. has low direct dependence on Middle Eastern energy, domestic energy prices will still rise in sync with international oil prices. Furthermore, rising energy prices will also push up the prices of imported goods in the U.S. through the global industrial chain costs. Especially since the U.S. consumer market relies heavily on imported goods, rising costs may transmit to domestic inflation through import prices, amplifying the impact of energy shocks on U.S. price levels.

Geopolitical conflicts are often accompanied by increased military spending. The pressure of U.S. fiscal debt has already significantly risen under the current high-interest rate environment, and if energy shocks lead to elevated inflation expectations, the Fed may maintain high-interest rates for a longer period, thereby further increasing the pressure of fiscal interest expenditures, making the U.S. debt problem more severe.

Additionally, Cheng Shi also warns that against the backdrop of an overall slowdown in the U.S. economy, geopolitical shocks could simultaneously drag down economic growth, putting the U.S. economy at risk of stagflation. In a stagflation environment, the adjustment space for monetary policy is often limited: on one hand, rising inflation pressure will constrain the space for rate cuts; on the other hand, economic growth slowdown weakens the feasibility of maintaining high-interest rates. Over the past five years, the U.S. has experienced a period of high inflation and aggressive rate hikes, and the scars from the economy have significantly increased market and residents’ sensitivity to inflation. If energy prices rise sharply, inflation expectations are more likely to fluctuate. Therefore, it is expected that the Federal Reserve will maintain a relatively cautious and hawkish stance in its policies to avoid losing control of inflation expectations. If energy price shocks gradually ease and geopolitical risks decrease, monetary policy may still return to a gradual rate-cutting track.

If the Middle Eastern conflict drags on, even the Fed Chair Kevin Warsh appointed by Trump may need to raise rates. Looking ahead, Medeiros analyzes that many factors depend on the duration of the situation in the Middle East. If the conflict ends quickly, the market may bring forward rate cut expectations; but if supply shocks last for months rather than weeks, the Fed’s policy support space will be limited, potentially forcing Kevin Warsh’s first action after taking office to be a rate hike rather than a rate cut.