The prospect for U.S. monetary policy appears to be shifting from interest rate cuts to potential hikes, driven by soaring oil prices following the escalation of military actions against Iran by the U.S. and Israel. With a potential economic shock looming, could rising energy prices act as a catalyst for the U.S. to expedite its exit from the Middle East?

The Federal Reserve is on high alert. Chicago Fed President Austan Goolsbee stated on Monday that the central bank might need to tighten monetary policy in response to the economic impact of rising oil prices. "All policy options are on the table, and interest rates could move in either direction. If inflation remains under control, we could return to an environment with multiple rate cuts this year. Conversely, if the situation deteriorates and inflation becomes unanchored, I wouldn't rule out the possibility of needing to raise rates," he said.

According to data from fuel research firm GasBuddy, the national average price for regular gasoline at pumps reached $3.95 last Saturday, the highest level since August 2022, representing a surge of over 30% since before the U.S.-Iran conflict began.

At its policy meeting last week, the Fed held interest rates steady and maintained its projection for rate cuts within the year. Only a small number of officials suggested amending the policy statement to indicate that the next move could be either a rate cut or a hike. The Fed's dual mandate involves stabilizing inflation and maintaining low unemployment. An oil price shock can easily trigger stagflation: it pushes up the cost of gasoline and food while simultaneously weakening demand and hampering the labor market. This places the Fed in a dilemma: should it prioritize supporting a softening job market or combat persistently rising prices?

Some economists anticipate that the Fed might make such a wording adjustment at its next meeting in late April. Tim Duy, Chief Economist at macro advisory firm SGH, believes that if the Fed ultimately decides to raise rates, it would signify a major policy pivot. For the past several months, Fed officials have been intensely focused on the path for rate cuts.

Goolsbee acknowledged that his concern about inflation slightly outweighs his concern about the labor market. "Inflation was already at an uncomfortably high level, having been significantly above target for an extended period. Now, with the addition of a potentially persistent gasoline price shock, this is precisely why the current economic situation is fraught with imminent risks," he said. This marks a notable shift in stance. Prior to the U.S.-Israel strikes on Iran, Goolsbee had repeatedly expressed the view that the Fed would ultimately cut rates within the year.

Despite this, several officials appointed by former President Trump continue to advocate for rate cuts. Fed Governor Stephen Milan stated the same day that he believes the Fed can still implement four rate cuts this year. Milan argued that the Fed's traditional policy approach is to look through oil price shocks: while they affect headline inflation, they do not typically feed through to core inflation, which excludes food and energy, unless longer-term inflation expectations spanning a year or more begin to rise. "We haven't seen that happen yet. The rise in gasoline prices hasn't triggered a wage-price spiral," he said, adding, "There are hardly any signs of that now. In fact, wage pressures have been moderating in recent years." Milan was the sole dissenter in last week's decision to hold rates steady, having argued for an immediate rate cut.

Meanwhile, Fed Vice Chair for Supervision Michelle Bowman said last Friday, "I remain concerned about the job market. Regarding the monetary policy outlook, we anticipate implementing three rate cuts before the end of 2026 to provide support for the labor market." Bowman noted that she believes it is too early to judge the long-term effects on U.S. economic activity or determine how this should be reflected in longer-term economic projections and considered for potential future rate adjustments in response to changing economic conditions.

Markets are still adjusting their expectations. President Trump has recently been pressuring Fed Chair Jerome Powell heavily to cut rates. However, as the conflict with Iran enters its fourth week, the bond market is starting to signal warnings about potential rate hikes. Short-term interest rate futures have begun pricing in the possibility of a Fed rate hike before year-end. Less than three weeks ago, markets were expecting a total of 60 basis points in rate cuts for the year. The war with Iran has not only completely reversed that expectation but flipped it entirely.

Last Thursday, the yield on the 2-year U.S. Treasury note, which is highly sensitive to interest rate expectations, surged 12 basis points to 3.92%, marking its largest single-day increase since April 2025. This move signaled a dramatic repricing by the market. So far this month, the 2-year yield has climbed 54 basis points—the largest increase since February 2023, when the Fed was in the midst of its most aggressive tightening cycle in forty years.

Earlier on Monday, the Polymarket platform showed the probability of a Fed rate hike in 2026 had jumped to 24%. The CME FedWatch Tool indicated a 40% chance of at least one rate hike by October. Even after Trump temporarily delayed further military action against Iran, the probability of a Fed rate hike within the year remained near 15% at the time of reporting.

In a recent report, Bank of America economist Aditya Bhave outlined three key conditions that would need to be met before the Fed seriously considers raising interest rates:

First, labor market stability. In 2022, the Fed continued hiking rates despite the economy entering a technical recession because the unemployment rate was below 4% and falling. Moderate job growth, stable initial jobless claims, and a steady job openings rate would provide support for hiking.

Second, core inflation exceeding 3.2%. A sustained $10 per barrel increase in WTI crude oil typically adds about 7 basis points of upward pressure to core inflation over the long term. If the Iran shock spreads to areas like shipping, natural gas, fertilizers, and aluminum, creating supply disruptions similar to those in 2021-2022, core inflation rising to 3.2% becomes a possibility.

Third, Powell remaining as Fed Chair. The nominee to replace him, Kevin Warsh, has not yet been confirmed by the Senate. Bank of America views Powell as a moderate dove who prioritizes the labor market when risks are balanced—but significantly more hawkish than the incoming Warsh, whose recent comments have emphasized the urgency of cutting rates.

Bhave's conclusion is that while a rate hike requires the simultaneous fulfillment of many conditions, these conditions are not out of reach.

According to the schedule, the CPI report due on April 10th could become the most significant economic data release in years. If the figure comes in at 3.4% or higher, coupled with sustained high oil prices due to Middle East tensions, the market discussion is likely to shift from "can the Fed hike?" to "when will the Fed hike?"