Interest rates face dual risks! The Federal Reserve has two options to signal a rate hike.

How the Iran War Reshapes the Federal Reserve’s Interest Rate Decision Environment

Market confidence in the Fed cutting interest rates has significantly weakened, although most still believe the next move will be a rate cut. However, BNP Paribas economists warn that the possibility of both rate hikes and cuts are roughly equal and represent a major underestimated tail risk.

Despite rising oil prices fueling inflation concerns, this will not force the Fed to hike rates this week; however, amid the 18th day of the Iran war, the possibility of a rate hike remains a key focus of this policy meeting.

Markets generally expect the Federal Open Market Committee (FOMC), responsible for setting rates, to keep policy rates unchanged at 3.50%-3.75% when it concludes its two-day meeting in the early hours of Thursday Beijing time. Most investors and economists still believe the next Fed move will be a rate cut, but since the U.S. and Israel launched airstrikes against Iran on February 28, market confidence in rate cuts has greatly diminished.

Last week, BNP Paribas economists wrote: “We believe that a shift by the FOMC toward a ‘symmetrical policy stance’—meaning roughly equal chances of rate hikes and cuts—is a major tail risk that is seriously underestimated.” Since the Iran war caused about one-fifth of global oil trade to halt, such speculation has become increasingly frequent.

Deutsche Bank economists are more direct: “Will the Fed hike in 2026?”

Two Paths for the Fed to Signal Rate Hikes

There are two ways the Fed could signal potential rate hikes.

The clearest but less likely method is a collective statement in the policy statement released at 2 a.m. Thursday, indicating that the next move could be either a rate hike or a rate cut.

More likely is that the latest quarterly economic projections released on the same day will show that if one or more policymakers believe that rate hikes are necessary this year or next, it will be reflected there.

This would undoubtedly draw criticism from U.S. President Trump, who has been pressuring Fed Chair Powell to cut rates. Trump has proposed nominating former Fed Governor Kevin Warsh—whom he believes supports rate cuts—to succeed Powell after his term ends in mid-May, but Warsh’s appointment still faces obstacles.

Inflation and Employment Pressures, Policy Balance Unsteady

Using the Fed’s preferred inflation indicator, U.S. inflation has exceeded the 2% target for five consecutive years. Even before the Iran conflict pushed oil prices up about 50% and caused a sharp rise in gasoline prices, several Fed officials had already advocated for rate hikes as a policy option.

Rising oil prices could broadly push up prices, leading financial markets to heavily bet that central banks in energy-dependent regions like Europe and Asia will have to raise rates to respond. Meanwhile, traders have reduced their bets on the Fed cutting rates, with many Wall Street institutions recently reversing their June rate cut forecasts and instead expecting the Fed to keep rates steady for a longer period.

Economists will closely watch key paragraphs in the policy statement for any wording changes that might indicate a shift in policymakers’ future rate stance.

Economic Forecasts May Show “Stagflation Tendency”

The Fed might focus on the likelihood of rate hikes by simply modifying its post-meeting statement: removing the language related to “additional rate cuts,” which has been present since the three cuts starting last September.

However, the mainstream view is that as the impact of last year’s tariff shocks wanes, it will be difficult for oil prices to quickly and deeply permeate the large U.S. economy, thereby reversing the downward inflation expectations later this year. This casts doubt on the prospects of rate hikes this year and reduces the likelihood that policymakers will collectively open the door to a rate increase this week.

BNP Paribas economists wrote: “Our baseline forecast is that policymakers will delay this adjustment because the U.S. labor market does not appear overheated, and there is uncertainty about the duration, severity, and economic impact of the war.”

Policy makers generally do not react to short-term spikes in commodity prices. They may also remain concerned about the resilience of the labor market, especially after unexpected layoffs last month. Rising oil prices could also slow economic growth—higher gasoline costs may lead consumers to cut back on other spending.

Therefore, analysts widely expect most Fed officials to still forecast at least one rate cut this year. Fed Governor Stephen Miran is expected to vote against any immediate rate hike, favoring a wait-and-see approach.

A survey of former Fed officials and staff shows a more hawkish stance. Conducted by Duke University visiting scholar and former Wall Street Journal reporter John Hilsenrath, out of 27 respondents, 13 believe rates should remain unchanged throughout the year, 6 advocate for hikes, and only 8 favor cuts.

“Dot Plot” May Show Divisions, Concerns of Stagflation

Overall, it is expected that Fed officials will raise their inflation forecasts for this year above the levels from December (the last time forecasts were released), but at the same time, they may lower economic growth forecasts and raise unemployment projections.

This concerning combination of forecasts—what Austan Goolsbee of the Chicago Fed calls “stagflation orientation,” where economic stagnation and high inflation coexist—means there could still be serious disagreements over which issue should take priority.

The “dot plot,” which shows the Fed’s interest rate path expectations, may reveal the intensity of these divisions, with one or more policymakers possibly marking higher rate forecasts for the end of the year.

Diane Swonk, chief economist at KPMG, said: “Opponents of rate cuts will likely forecast more cuts for the remainder of the year, while some hawkish participants may still see the need for hikes. The tension between the Fed’s dual mandate of price stability and maximum employment will be reflected in the rate projections of participants.”