Since the escalation of Middle East tensions in late February, crude oil prices have continued to rise, raising concerns about stagflation. The hawkish tone of the March FOMC meeting has triggered a tightening trade, with markets beginning to speculate about the possibility of a Fed rate hike within the year. While the Fed's hawkish policy stance aligns with expectations, maintaining current interest rates—rather than cutting them—may represent its bottom line. Attention should now turn to the potential negative feedback from tightening financial conditions.

Markets are currently pricing in the possibility of a Fed rate hike in 2026, though this remains a low-probability scenario. The prolonged nature of Middle East geopolitical conflicts and the sustained increase in oil prices are amplifying stagflation risks and liquidity tightening pressures. Following the March FOMC meeting, U.S. financial stress has intensified significantly, leading markets to weigh the likelihood of the Fed's next move being a rate hike. As of March 20, the probability of a 25-basis-point hike in 2026 has risen from zero a month ago to 12%.

We believe that holding rates steady, rather than cutting them, is likely the Fed's baseline stance for 2026—a rate hike remains highly unlikely. This view is based on two key factors: first, the conditions necessary for a repeat of the 1970s-style "Great Stagflation" are not in place; second, near-term inflationary pressures are likely to suppress demand through mechanisms such as real income effects, financial conditions, wealth effects, and expectations, thereby exerting a reflexive impact on oil prices and inflation.

A repeat of the "Great Stagflation" driven by oil supply shocks appears unlikely. However, a peak in oil prices may be a prerequisite for the Fed to resume rate cuts. The core mechanism of stagflation—the wage-price spiral—is fragile, as sustained inflation from supply-side shocks depends critically on wages keeping pace with rising prices. Current U.S. conditions do not support such a dynamic, as seen during the 2022 Russia-Ukraine conflict, when even a sharp rise in oil prices did not trigger a sustained inflationary spiral.

In response to inflationary pressures stemming from oil supply shocks, the Fed tends to prioritize near-term inflation risks, often adopting a wait-and-see approach before adjusting policy as needed. Historical examples, such as the 1973–1974 oil crisis and the 2003 Iraq War, show that geopolitical conflicts and their impact on oil prices are often short-lived, rarely altering the broader direction of monetary policy. Currently, the Fed is in the final stages of its rate-cutting cycle, and a peak in oil prices may be the key factor that allows it to resume easing.

While easing geopolitical tensions could help oil prices peak, the reflexive relationship between oil, financial conditions, and the economy should not be overlooked. Oil prices have become an anchor for pricing major asset classes. Although markets are closely monitoring developments in the Middle East, the feedback loop between oil prices, financial conditions, and economic activity remains critical. Inflation driven by oil supply shocks can dampen overall demand through real income and financial channels, ultimately putting downward pressure on oil prices.

Markets are already caught in a negative feedback loop between oil, finance, and the economy. When market expectations for Fed rate cuts become overly pessimistic—such as pricing in a rate hike within the year—the actual likelihood of rate cuts may, in fact, increase. Over the medium term, an unfavorable scenario for monetary and financial conditions would be one in which geopolitical tensions prove temporary, but the post-conflict rise in oil prices exceeds expectations in magnitude or duration.

Risks to monitor include further escalation of geopolitical conflicts, a sharper-than-expected slowdown in the U.S. economy, and an unexpectedly hawkish shift by the Fed.