“Only a Hold or a Hike”: U.S. Rate Path Reverses as Prolonged Iran War Rattles Oil, Inflation and Bond Markets

Fed officials discussed the possibility of raising interest rates at the July FOMC meeting
Middle East uncertainty fuels energy price volatility and compounds inflation risks
Trump faces a midterm-election dilemma, while Iran’s economy also enters crisis mode

Officials at the U.S. Federal Reserve have raised the need for an interest-rate increase. With the prolonged Iran war amplifying inflation uncertainty, policymakers appear to be recalibrating the direction of monetary policy while leaving the door open to further tightening. U.S. President Donald Trump has once again pressed the Fed to cut rates, but the prevailing market view is that such demands are highly unlikely to be accommodated in the near term. Analysts say the future rate path will most likely hinge on how the confrontation between the United States and Iran unfolds and on the trajectory of energy prices.

July FOMC Minutes Released

According to the minutes of the July 28–29 Federal Open Market Committee (FOMC) meeting released by the Fed on August 19 local time, many participants concluded that interest rates would need to be raised if inflation failed to decline toward the Fed’s 2% target. Bloomberg explained that, in the terminology typically used in Fed minutes, “many” generally refers to nearly half of the 19 policymakers, including those without voting rights. At the meeting, three officials—Dallas Federal Reserve Bank President Lorie Logan, Cleveland Fed President Beth Hammack and Minneapolis Fed President Neel Kashkari—reportedly advocated an actual 0.25-percentage-point increase and dissented from the decision to hold rates steady. The Fed left its benchmark interest rate unchanged at 3.50–3.75% last month.

Officials supporting a rate increase stressed that “inflationary pressures are broad-based” and that “a more restrictive policy stance should be adopted to achieve the goals of price stability and maximum employment.” They warned that delaying an increase could create the risk of having to implement “steeper and potentially more costly” tightening measures later. The minutes made no mention of any views supporting an interest-rate cut. This represents a significant shift, considering that expectations for rate cuts within the year had prevailed as recently as early this year amid moderating inflation. Officials assessed that real economic activity in the United States had remained resilient and that the labor market was stable. Many participants, however, noted that a renewed escalation of conflict in the Middle East could prolong supply-chain disruptions and intensify price pressures.

Table 1. Key Discussions on the Benchmark Interest Rate at the July FOMC Meeting

Trump Presses for Interest-Rate Cuts

On the day the minutes were released, U.S. President Donald Trump once again pressured the Fed, saying that he “really wants interest rates to come down.” Speaking to reporters at the White House, he complained that “the Federal Reserve Board is political,” adding that “people appointed by Barack Obama, Joe Biden and me remain on the board and voted to raise rates.” He continued, “Whenever we release good numbers, the Fed is so afraid of inflation that it keeps raising rates,” stressing that “rates should be allowed to come down because of America’s success, not be raised because of it.”

At first glance, recently released U.S. inflation data appear to lend some support to Trump’s complaints. The U.S. Consumer Price Index (CPI) rose just 0.1% month on month last month, while its year-on-year increase slowed to 3.4% from 3.5% in June. Core CPI inflation also eased to 2.5% year on year from 2.6% in the previous month. In effect, the inflation risks that had intensified rapidly following the outbreak of the Iran war early this year appeared to be losing momentum.

International Oil Prices Stir Again

It would nevertheless be premature to conclude from those figures alone that inflation risks have dissipated. Energy was the principal factor pulling inflation lower last month. Energy prices fell 1.5% from the previous month, while gasoline prices declined 2.9%. The problem is that the downward trend did not last long. The adjustment in energy prices at the time stemmed from a partial recovery in crude-oil shipments through the Strait of Hormuz after the United States and Iran agreed to a provisional ceasefire in June. At present, however, the provisional agreement has effectively collapsed without the implementation of key provisions, including the reopening of the Strait of Hormuz, while fighting and attacks on vessels resumed last month. International oil prices have consequently rebounded sharply. On August 21, October Brent crude futures were trading at around $93 a barrel on London’s ICE Futures Europe exchange.

Supply disruptions also persist. In a recent report, the International Energy Agency (IEA) said, “The effective closure of the Strait of Hormuz and supply disruptions across the Middle East following the outbreak of war have reduced global oil inventories by a cumulative 410 million barrels,” adding that “daily oil production in the Gulf region has also fallen by approximately 8.3 million barrels from prewar levels.” As a result, global crude-oil supply is expected to decline by an average of 4.3 million barrels per day this year, while the supply deficit is projected to reach 1.8 million barrels per day in the third quarter. The U.S. Energy Information Administration (EIA) likewise noted that crude oil and petroleum-product shipments through the Strait of Hormuz averaged 4.9 million barrels per day in the second quarter, less than one-quarter of the 21.6 million barrels per day recorded in the fourth quarter of last year before the war. Such supply shocks affect not only crude oil but also refined-product prices, driving up transportation and logistics costs and ultimately fueling increases in final-goods prices.

Markets Focus on Inflation

Markets are reacting immediately to these risks. In the U.S. Treasury market, selling pressure has persisted, particularly in longer-dated securities. The 30-year yield climbed as high as 5.337% intraday on August 18, marking its highest level in approximately 19 years since 2007, while the 10-year yield surged to 4.748% on the same day. Market expectations for interest rates have also shifted substantially. According to the CME FedWatch Tool, as of August 21, markets assigned a 64.7% probability that the Fed would maintain the current 3.50–3.75% rate at its September FOMC meeting and a 35.3% probability that it would raise rates by 0.25 percentage points. By contrast, the probability of a rate cut was effectively 0%.

For the October meeting, a hold remained the most likely outcome, with a probability of 51.3%. That was followed by a 41.4% probability of a 0.25-percentage-point increase and a 7.3% probability of a 0.5-percentage-point increase. Expectations for tightening become even more pronounced toward year-end. For the December FOMC meeting, the FedWatch Tool assigns no probability whatsoever to rates falling below their current level, while the probability of rates remaining unchanged stands at just 33.4%. By contrast, the probability of a single increase to 3.75–4.00% reaches 44.9%, while the probability of rates rising to 4.00–4.25% or higher has climbed to 21.8%.

Where Is the U.S.–Iran Conflict Headed?

The key variable that will ultimately shape market sentiment is which course the United States and Iran choose. Trump, for his part, is caught in a political dilemma without a viable exit strategy. Reuters recently assessed that “President Trump is caught between accepting a compromise that grants Iran substantial authority over the management of the Strait of Hormuz and again escalating military attacks while risking a protracted war.” The former could amount to a de facto recognition of Iran’s control over the strait, which the United States had opposed even before the war. The latter could place an additional burden on Republicans ahead of the November midterm elections amid a mounting array of adverse factors, including high gasoline prices, low approval ratings and war fatigue.

Iran is equally cornered. According to the Statistical Center of Iran, the country’s consumer prices surged 87.9% year on year last month. The average inflation rate over the latest 12 months also reached 66%. The unemployment rate this spring stood at 9.1%, up 1.8 percentage points from the same period last year, while the number of employed people declined by approximately 450,000. The economic crisis has deepened as war-related production disruptions and reconstruction costs compound pre-existing problems, including high inflation, a weakening rial, energy shortages and Western sanctions. U.S. economic pressure on Iran also poses a clear threat. The Trump administration recently signaled its intention to cut off Iran’s financial lifelines by announcing plans to tighten secondary sanctions on foreign companies and countries that purchase Iranian oil or conduct transactions with Iranian financial institutions.