War Shatters Rate Cut Expectations! Fed Trapped by Oil Prices: Probability of Rate Hikes Exceeds Rate Cuts for First Time

Reuters Finance App — The Iran war has completely overturned the Fed’s outlook on borrowing costs. The Atlanta Fed Market Probability Tracker shows that for the first time in years, the probability of a Fed rate hike in the next three months (25%) exceeds the chance of a cut (20%). Before the outbreak of war, the probability of a rate cut was as high as 40%, with only a 5% chance of a hike. The surge in energy prices is reigniting inflation, forcing the Fed to reassess its tightening path, with short-term hawkish expectations dominating the market.

This Wednesday (March 18), a two-day Fed meeting is expected to keep rates unchanged, but hawkish sentiment remains dominant, with the future path depending on the duration of the conflict.

Probability of rate hikes exceeding cuts in the next 3 months

According to the Atlanta Fed’s market probability tracker based on CME Group and New York Fed trading data:

• Probability of a rate hike in the next 3 months: 25%
• Probability of a rate cut: 20%
• Probability of holding steady: dominant (98.9% chance of no change at Wednesday’s meeting).

This is the first time since this rate hike cycle that the market has priced in a higher probability of a rate increase than a cut, marking a substantial shift in monetary policy expectations due to the Iran war.

Pre-war: 40% chance of cut vs. 5% hike; now completely reversed

Before the war, the market priced a 40% chance of the Fed cutting rates next, with only a 5% chance of a hike. But the Iran conflict has caused energy prices to surge and inflation expectations to reignite, leading to a complete reversal within just two weeks.

The market has significantly reduced its bets on rate cuts in 2026 and is even pricing in the risk of additional hikes. The Fed’s dual mandate (full employment + price stability) faces a dilemma: energy shocks push inflation higher, requiring tightening, but at the same time, growth and employment need easing support.

Energy prices surge, dragging inflation higher, forcing the Fed to reassess tightening

Disruption of the Strait of Hormuz has cut about 20% of global oil supply, with oil prices oscillating at high levels, rising nearly 50% in two weeks. The energy shock has spread from gasoline and aviation fuel to transportation, chemicals, manufacturing, and agriculture, pushing up core inflation and living costs.

Fed officials need to evaluate whether the conflict will lead to sustained high inflation or create a stagflation scenario of “slowdown + rising prices.” In the short term, hawkish stance prevails, and rate hike discussions are resurfacing.

Dual mandate of employment and inflation faces dilemma; high oil prices amplify stagflation risk

The Fed must balance price stability with full employment. February’s unexpectedly weak non-farm payrolls (-92,000) show slowing growth risks, but soaring oil prices reignite inflation pressures.

Too rapid easing could repeat the inflation runaway of 2021-2022; premature tightening could worsen economic slowdown risks.

Market pricing has shifted toward “higher and longer,” with short-term financial conditions tightening. The energy crisis may be the “last straw,” significantly increasing stagflation risks.

Wednesday’s meeting likely to hold rates steady; market signals overwhelmingly aligned

The FOMC is expected to keep rates at 3.5%-3.75%, with a 98.9% probability according to CME FedWatch. Given high uncertainty, the simplest approach may be to follow last December’s forecast—only one rate cut this year.

Markets will closely watch the policy statement, economic projections (SEP), dot plot, and Powell’s press conference for assessments of the Middle East conflict’s impact. Any hawkish language could further tighten financial conditions.

Hawkish expectations dominate in the short term; medium to long-term depends on conflict intensity and duration

In the short term, hawkish expectations dominate: oil prices remain high, inflation expectations stubbornly rise, and the rate cut path shifts significantly, even pricing in the risk of additional hikes.

The medium to long-term rate outlook depends on the severity and duration of the conflict: if it ends in weeks with quick supply recovery, rate cut expectations may reemerge; if it drags on, stagflation risks rise sharply, and the Fed may be forced to consider resuming hikes.

Investors should watch next week’s statement and dot plot changes, monitor energy secretary forecasts and battlefield developments, as volatility remains high.

Summary

The Iran war has fundamentally changed the Fed’s outlook on borrowing costs. The Atlanta Fed tracker shows a 25% chance of a rate hike in the next three months, surpassing the 20% chance of a cut—marking the first such occurrence in this cycle. Pre-war: 40% chance of cut vs. 5% hike; now completely reversed. Oil prices have surged nearly 50% in two weeks, intensifying inflation concerns, and the Fed faces a dilemma with its dual mandate.

Wednesday’s meeting is expected to keep rates unchanged, following last December’s “only one cut” forecast. Short-term hawkish expectations dominate, while medium to long-term outlook depends on conflict severity and duration. Investors should focus on policy statements, dot plots, and Powell’s tone, as any hawkish signals could further tighten financial conditions. The energy crisis may be the “last straw,” significantly increasing stagflation risks.

(Edited by: Wang Zhiqiang HF013)