“War Shakes U.S. Monetary Policy”: Fed’s December Rate Decision Unclear as Middle East Inflation Pressures and Peace Talks Complicate Outlook

U.S. Fed holds benchmark rate steady in October; forecasts divided on another hike in December
Inflation fueled by Iran war persists, adding to monetary policy challenges amid uncertainty over an end to the war
U.S. and Iran pursue ceasefire talks as Europe steps up diplomacy to end Ukraine war

With the U.S. Federal Reserve (Fed) holding its policy rate steady at the October Federal Open Market Committee (FOMC) meeting, market forecasts for the December rate path are divided. Caution has spread amid concerns that monetary policy cannot directly control supply shocks caused by a prolonged Middle East war. The Fed’s policy path is expected to depend heavily on the course of the Middle East war, whether shipping through the Strait of Hormuz returns to normal, and how quickly global oil prices stabilize.

Fed Holds Rates Steady at October FOMC Meeting

On the 28th (all dates hereafter are local time), the U.S. Federal Reserve (Fed) announced that it had held its benchmark interest rate steady at an annual 3.75–4.00% at its regular FOMC meeting. The decision marked a pause after last month’s rate increase, the first in 3 years and 2 months. At a press conference immediately after the meeting, Fed Chair Kevin Warsh said, “Bringing inflation down is our responsibility,” adding that this was “why the FOMC’s discussions over the past two days focused primarily on our price stability mandate.” He emphasized, “Energy and related prices have risen again in recent weeks, and our job is to ensure that relative price changes in certain sectors do not spread across the broader economy.” He avoided specifics on the future direction of monetary policy, saying, “I do not favor signaling policy decisions in advance, nor do I prejudge the outcome of meetings.”

With Chair Warsh stopping short of clearly signaling a commitment to further tightening, experts are increasingly divided. In a commentary, Seema Shah, chief global strategist at Principal Asset Management, said, “The decision to hold rates steady was wise in that it gives the Fed time to gather more data amid global economic uncertainty,” but predicted that “there will be rate hikes in December and early 2027.” Kay Haigh, global co-head of fixed income and liquidity solutions at Goldman Sachs Asset Management, also said, “We expect the Fed to resume rate hikes in December,” adding, “The elevated September consumer price index (CPI) reading is a reminder that upside inflation risks remain, and the Fed is likely to seek additional ‘insurance’ against them.”

Caution Spreads in Parts of the Market

Others, however, say it is difficult to be certain whether another rate hike will occur. According to Business Insider on the 28th, Steve Rick, chief economist at TruStage, said, “Monetary policy works with long and variable lags,” adding, “Before deciding whether additional tightening is necessary, the Fed will want to see how the high interest rates already in place affect consumer spending, business investment and employment, and there is no need to rush.” Andrew Davis, head of investment strategy at Bryn Mawr Trust, also said, “The Fed’s wait-and-see stance is reasonable given that the labor market is cooling without showing the broad-based deterioration commonly seen during recessions.” He added, “Higher borrowing costs alone may achieve some of the tightening the Fed intended, potentially removing the need for additional rate increases.”

In financial markets, expectations for further tightening weakened somewhat, while concerns over long-term inflation came to the fore. The probability of an additional 0.25-percentage-point rate hike in December implied by federal funds futures fell 5.9 percentage points, from 90.7% before the FOMC meeting to 84.8% afterward. The expected cumulative number of 0.25-percentage-point hikes through the first half of 2027 also declined from 2.8 to 2.6. Following Chair Warsh’s press conference on the 28th, the yield on the two-year U.S. Treasury note, which is sensitive to monetary policy, fell 3.8 basis points (1 basis point = 0.01 percentage point) to 4.700% annually. The 10-year yield rose 5 basis points to 5.042%, while the 30-year yield increased 6 basis points to 5.367%. As a result, the spread between two-year and 10-year yields widened to about 34.2 basis points.

War-Driven Inflation Risks

The uncertainty over whether the Fed will raise rates again stems from the close connection between current U.S. inflation and the energy supply shock caused by the Middle East war. Following the outbreak of the Iran war, shipping through the Strait of Hormuz, which carries about 20% of the world’s oil supply, was effectively blocked, sending global oil prices sharply higher. According to the World Bank, Brent crude, which was about USD 72 (approximately USD 73.85) per barrel in late February, just before the war, averaged more than USD 100 (approximately USD 103) in March. Although some export volumes subsequently recovered, damage to Saudi Arabia’s East-West Pipeline last month disrupted oil transportation, reigniting the rise in prices. On the 28th, Brent crude futures closed at USD 115.32 (approximately USD 118) per barrel, while U.S. West Texas Intermediate (WTI) crude futures settled at USD 102.78 (approximately USD 105).

These rising global oil prices are directly fueling U.S. inflation. According to data released by the U.S. Bureau of Labor Statistics (BLS) on the 14th, September CPI rose 3.7% year over year, an acceleration of 0.3 percentage points from August’s 3.4%. Energy prices, in particular, surged 20.4% from a year earlier, while gasoline prices jumped 34.2%. The resulting cost burden on U.S. households is also substantial. The Centre for Research on Energy and Clean Air (CREA) estimates that, from the outbreak of the war through mid-October, U.S. consumers incurred an average of USD 471 (approximately USD 483) per person in additional fuel costs due to higher oil prices, 7.9 times the global average of about USD 60 (approximately USD 61.54).

Table 1. How Supply Shocks from the Middle East War Affect the U.S. Economy

An End to the War Is Crucial, but Uncertainty Remains High

The risk of further increases in food prices is also growing. Rising global oil and natural gas prices have increased the energy costs of operating farm machinery and processing and transporting food. Meanwhile, disruptions to shipments of fertilizer raw materials and finished products through the Strait of Hormuz are putting upward pressure on agricultural production costs overall. Last month, U.S. consumer food prices rose 2.5% from a year earlier, with food-at-home prices up 1.8% and dining-out prices up 3.5%. By category, fruit and vegetable prices rose 3.7%, nonalcoholic beverages 3.8%, and cereals and bakery products 2.1%.

The problem is that it is difficult to predict when these inflationary pressures will ease. Because a substantial share of current inflation stems from energy supply disruptions caused by the Middle East war, an end to the war itself is likely to be a major determinant of the price outlook. One market expert said, “With the timing of the war’s end difficult to gauge, even if the Fed raises rates, it will struggle to address the underlying causes of rising prices, such as oil supply shortages.” The expert added, “Rather than rushing into monetary tightening in response to temporary inflation driven by supply-side factors, the Fed is more likely to decide when to raise rates again while monitoring the course of the war and whether energy prices stabilize.”

Western Countries Signal Willingness to Negotiate

As economic uncertainty grows amid the prolonged war, Western countries have begun exploring opportunities for diplomatic negotiations. According to Reuters, Qatari mediators delivered a new draft peace agreement to Iran on the 25th aimed at ending the war between the United States and Iran. The proposal called for both sides to implement confidence-building measures in stages over 7 days. Key negotiating issues included disagreements over Iran’s nuclear program, restoring normal shipping through the Strait of Hormuz, and lifting economic sanctions on Iran. However, the United States continues to combine dialogue with military pressure, repeatedly signaling the possibility of additional attacks on Iran. Iran, too, responded negatively, saying that the latest proposal delivered by Qatar contained provisions it would find difficult to accept.

In Europe, diplomacy to end the war is taking more concrete shape around the Ukraine war rather than the Iran war. On the 27th, Finnish President Alexander Stubb and Norwegian Prime Minister Jonas Gahr Støre spoke with Russian President Vladimir Putin for about 1 hour and 30 minutes, urging an end to the war and a reduction in military tensions. In particular, the two leaders called for practical de-escalation measures, including a halt to attacks on Ukraine’s energy infrastructure, and briefed Ukrainian President Volodymyr Zelenskyy on the discussions immediately afterward. Major European countries are also exploring participation in trilateral peace talks among the United States, Russia and Ukraine that could resume early next month in Abu Dhabi, United Arab Emirates (UAE). Russia, however, maintains that the attendance of a European delegation has not been discussed, and neither the specific schedule nor participation has been finalized.