The Federal Reserve finds itself in an unusually uncomfortable position. With oil prices up more than 50% since the conflict in Iran began, inflation expectations are rising sharply, and pressure is mounting on policymakers to respond. But the bond market may be doing the heavy lifting on its own.
In the first month of the war, government bond yields across short and long maturities have risen significantly as investors reprice assets to reflect a rapidly shifting inflation outlook. The oil shock has effectively dismantled earlier expectations for subdued inflation and cautious central bank behavior, catching many in the financial community off guard.
Fed Chair Powell caught between two difficult realities
Fed Chair Jerome Powell acknowledged this week that the central bank has historically looked past oil price shocks without adjusting rates. But he also conceded that this moment is different. Inflation has remained above the Fed’s 2% target for five years now, and another spike driven by energy costs is harder to dismiss as temporary.
At least one regional Fed president has pushed back on any instinct to wait it out, arguing that with inflation already running hot, assuming the latest surge will fade on its own is a risk the Fed cannot afford to take.
Powell also noted that inflation expectations appear reasonably anchored beyond the short term, but that the question of what action to take may eventually need a direct answer.
Bond yields are already pointing to higher borrowing costs
The yield on the two-year Treasury, widely considered the clearest signal of where investors believe the federal funds rate is headed, climbed to 3.8% and briefly touched 4% in late March, up from 3.4% before the conflict began. That puts it above the current federal funds rate range of 3.5% to 3.75%.
The 10-year Treasury yield has moved from roughly 3.96% to as high as 4.4%, breaking through the 4.25% ceiling that had largely held since last August. That move matters beyond Wall Street. The 10-year rate directly influences 30-year fixed mortgage rates, which have risen more than half a percentage point on average in just three weeks, erasing rate relief that had briefly brought them to three-year lows. The national average for a 30-year fixed mortgage now sits at 6.47%, according to the Zillow lender marketplace.
For consumers carrying auto loans, credit cards, and other variable-rate debt, the outlook has darkened. Relief that once seemed within reach has been pushed further out, with the Fed’s easing cycle effectively paused due to the energy shock tied to the Iran conflict.
A rate hike is no longer unthinkable
Before the conflict, bond markets were pricing in two to three quarter-point rate cuts this year. That expectation has fully evaporated. As of Tuesday, futures markets are not pricing in any cuts for the year, and a rate hike is no longer entirely off the table, though most Fed officials do not view it as their base case.
The Fed now projects headline and core inflation, which strips out food and energy, to reach 2.7% this year, up from an earlier forecast of 2.5%. Officials expect the oil price spike to push overall inflation higher in the coming months, with some hoping for a partial reversal later in the year if hostilities ease and oil prices come down.
Markets are also weighing the growth implications. The yield curve has flattened, a signal that investors are growing more cautious about the economic outlook. If oil remains elevated, analysts warn that demand destruction becomes an increasingly real risk. That concern is amplified today because the conditions that cushioned the economy during the 2022 oil shock, including pandemic-era stimulus, a tight labor market, and strong wage growth, are no longer present. Low and middle income households are under measurable strain, and the labor market has cooled considerably.
In that environment, some economists argue the Fed’s best move may be no move at all. A sustained oil shock in today’s economy, the thinking goes, could tip into recession faster than it triggers runaway inflation, making aggressive rate hikes the wrong tool entirely.
