In just three weeks, the narrative in the interest rate market has undergone a near-dramatic reversal. Previously, traders were generally betting on a rate-cutting cycle starting in 2026, and more than once; however, with the sudden escalation of tensions in the Middle East, especially the disruption of global energy supplies caused by the conflict in Iran, oil prices quickly surged to triple digits (Brent crude broke through $110), reigniting inflation expectations.



The market quickly shifted, even beginning to discuss whether the Federal Reserve needs to raise interest rates again. This shift from a "consensus on easing" to "extreme uncertainty" is essentially a linear extrapolation of geopolitical shocks, rather than a fundamental change in macroeconomic fundamentals. The market rapidly shifted from a single narrative to opposing narratives, exhibiting typical characteristics of emotional overreaction.

The Federal Reserve kept the target range for the federal funds rate unchanged at 3.50%-3.75% at its March 18 meeting, marking the third consecutive pause since three rate cuts in the second half of last year. The dot plot shows that the median expectation is for only one more 25-basis-point rate cut in 2026, keeping the year-end rate around 3.25%-3.50%; and another cut to 3.00%-3.25% in 2027.

This path is largely in line with the projection from last December, although the oil price shock has led to an upward revision of inflation expectations: the median PCE inflation in 2026 is expected to rise from 2.4% to 2.7%, and core PCE is also expected to rise to 2.7%; the unemployment rate is expected to remain at 4.4%.

Powell's remarks and the trade-off between the Fed's dual mandate

In the post-meeting press conference, Powell emphasized that the Fed’s dual mandate—maximizing employment and stabilizing prices—faces two risks: rising oil prices will push up overall inflation in the short term, but at the same time bring downward pressure, suppressing consumption and employment.

He pointed out that "the impact of the situation in the Middle East on the US economy is uncertain," and that the recent energy price shock "will certainly be reflected in inflation," but "it is too early to judge its scope and duration." Powell clearly stated that the Fed is "well positioned" and can decide on subsequent adjustments based on future data, evolving prospects, and the balance of risks, without needing to react immediately. He described the oil price shock as likely to be "temporary," emphasizing that the policy path is highly conditional.

The job market has become a potential breakthrough point.

The labor market has become a potential point of contention. Non-farm payrolls unexpectedly fell by 92,000 in February, a rare negative growth since the pandemic, and the unemployment rate rose from 4.3% to 4.4%. Layoffs occurred in sectors such as healthcare and transportation, consumer confidence declined, and slower labor force participation and immigration further dragged down job growth.

While overall economic activity continues to expand at a solid pace (2026 GDP forecast revised upward to 2.4%), signs of weakening employment are emerging. If this trend continues, a repeat of the spring-summer weakness could occur, and rising unemployment will force the Federal Reserve to reassess its path.

Two paths to oil price shocks: mild inflation vs. recession triggers

Oil price shocks can take two possible forms, which determine their net impact on policy. If oil prices rise moderately and steadily, they will act more like an "inflation booster," not significantly damaging demand but rather reinforcing the logic of "high interest rates for longer periods." However, if there is a sharp, uncontrolled surge (such as Brent crude breaking through $110), it will quickly suppress consumption, corporate profits, and investment, turning into a recession trigger.

The "slope" of oil prices is more crucial than their absolute level: a slow rise leans towards a hawkish stance, while a steep rise may indicate a dovish one. Historical experience shows that, between the risks of stagflation and recession, the Federal Reserve often prioritizes addressing the latter by shifting towards easing.

Wall Street expectations are divided: Mainstream institutions postpone rate cuts but have not completely ruled them out.

Wall Street's expectations for the Federal Reserve's path in 2026 are clearly diverging, but the dovish logic has not completely disappeared. Citigroup remains relatively dovish, expecting three rate cuts totaling 75 basis points throughout the year (possibly starting in the middle of the year); mainstream institutions such as Goldman Sachs and Morgan Stanley have postponed the first rate cut to the second half of the year (such as September), expecting a total of 50 basis points; a few extremely hawkish voices (such as JPMorgan Chase, HSBC, and Standard Chartered) predict zero rate cuts throughout the year, and some analysts even believe that rate hikes are necessary.

Overall, many institutions believe the oil price shock is "temporary" and can be observed. If employment data confirms a continued deterioration, the Federal Reserve will be forced to shift towards easing. Market futures pricing currently reflects a rate cut of about 40-50 basis points, a slight decrease from pre-conflict levels, but it has not completely closed the door to easing throughout the year.

Policy lag and path dependence: Market overshooting is exaggerated.

A significant problem in the current market is the overreaction to immediate shocks while relatively ignoring the lag in monetary policy. Core inflation remains around 3%, but real momentum has begun to weaken, and the effects of the previous tightening cycle are gradually becoming apparent. Even if a short-term rebound in energy prices pushes up inflation, the Federal Reserve may not immediately shift to raising interest rates.

More importantly, once the market establishes the expectation that "high interest rates will be maintained for longer," this itself constitutes an additional tightening force, which to some extent replaces actual interest rate hikes.

Conclusion: The key to 2026 lies in "when will we be forced to cut interest rates"

The real question in 2026 is not "whether to cut interest rates," but "when to be forced to cut interest rates." Based on current information, the market's swing from "multiple interest rate cuts" to "possible interest rate hikes" is essentially an overreaction of sentiment to uncertainty.

The Federal Reserve is likely to remain on the sidelines in the short term, with higher interest rates expected to persist for longer. However, if a weakening employment situation is confirmed, or if an unexpected oil price shock leads to demand destruction, the rate-cutting cycle will resume. Historical path dependence shows that the Fed tends to "passively cut rates" during economic slowdowns rather than "actively cut rates" during orderly declines in inflation.

Ultimately, the Federal Reserve will navigate a trade-off between inflation and employment risks. Continuous monitoring of subsequent non-farm payroll and CPI data, as well as developments in the Middle East, will be key signals for determining a policy shift.