Fed Shifts to Hawkish Stance Amid Middle East Conflict

(MENAFN) The escalating conflict in the Middle East is sending shockwaves through the global inflation outlook, with surging oil prices stoking upward price pressures worldwide while market expectations signal a decisive pivot by the Federal Reserve from a dovish to a hawkish stance over the past month.

The war — ignited by the joint US-Israeli offensive against Iran on Feb. 28 and Tehran's subsequent retaliatory strikes — is nearing its first month, with its economic footprint growing increasingly difficult to ignore.

Sustained attacks on oil infrastructure by both sides have stoked fears over energy supply, pushing crude prices sharply higher and sending ripple effects through global inflation trajectories, growth forecasts, and monetary policy calculations.

The Fed, which had been widely expected to deliver two rate cuts before year-end, now faces mounting pressure to hold — or even hike — as war-driven energy shocks keep inflationary forces alive. Rate cut expectations have all but evaporated in money markets, replaced by more aggressive projections as the conflict's economic toll deepens.

Selling pressure has simultaneously gripped government bond markets, with the US 10-year Treasury yield climbing to 4.46% — testing its highest level since July 2025. The yield started the month below 4% before surging to 4.4% by Monday as March drew to a close.

US inflation has averaged approximately 3.5% annually over the past seven years, running well above the Fed's 2% target, an expert told media.

Hande Sekerci, chief economist at Türkiye-based IS Asset Management, identified two critical near-term risk factors: the emergence of an oil supply shock stemming from the Middle East crisis, and the imminent arrival of a new Fed chair whose credibility has yet to be stress-tested by markets.

"The current yield is priced optimistically considering the risk of prolonged geopolitical tensions and the global energy price shock, and its potential implications for US inflation," Sekerci said, warning that the balance of risks for US bond yields tilts to the upside if the conflict proves protracted.

She acknowledged that central banks retain tools to blunt supply-side inflation, but cautioned that deploying them creates a difficult policy trade-off. "Rises in oil prices are both fueling inflationary pressures and weakening growth dynamics through cost channels that spread across the broader economy," Sekerci said.

The dilemma facing policymakers, she argued, is rooted in the fundamental tension between inflation control and economic growth — a challenge with deep historical precedent.

"Former Fed Chair Ben Bernanke's analysis in 2004 remains valid in this context — policy cannot counteract both the recessionary and inflationary effects of rising oil prices, and while efforts to support growth via rate cuts risk boosting inflationary pressure, tightening policy to control inflation could deepen the economic slowdown, so the policy choice here is shaped by the risk balance between price stability and employment targets," she said.

The war has already forced a sweeping recalibration of guidance from major central banks. "While the Fed emphasized persisting uncertainties over the war's impact on the economy in March, expectations priced at the start of 2026 anticipating rate cuts to continue gave way to estimates of potential rate hikes during the year," Sekerci noted.

She suggested the Fed may sustain a wait-and-see posture in the near term, though the odds of an early rate hike are rising. "We think the first step by the Fed, after the new chair adopts a wait-and-see approach for a while, could likely come as a rate hike either by the end of this year or in January 2027," Sekerci added.

The picture diverges somewhat across the Atlantic. In the eurozone and the UK — where price stability takes precedence over growth mandates — money markets are pricing in rate hikes with growing conviction. The European Central Bank (ECB) has already shifted to a more guarded posture on inflation risks.

"Global markets expect an ECB rate hike in June with almost certainty, but expectations over the euro-dollar exchange rate have weakened, despite rate hike estimates, the exchange rate is expected to settle at a lower level by year-end versus previous scenarios. Overall, global energy price shocks have had a more negative impact on eurozone growth, while the primary damage to the US economy has driven inflation higher than in the eurozone," Sekerci said.

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