At the start of the year, investors were focused on a familiar set of questions. The timing of rate cuts, a leadership transition at the Federal Reserve, and a shift toward a more forward-looking, growth-oriented framework were expected to define the outlook. Markets were actively debating how aggressive the Fed might be in easing, with expectations tied in part to Kevin Warsh potentially succeeding Jerome Powell.

That narrative has since been disrupted. The escalation of the Iran conflict has pushed energy prices and inflation risk back to the center of the macro conversation. The closure of the Strait of Hormuz, through which roughly 20% of the world’s oil and liquified natural gas travels, forced a broad reassessment of the growth outlook and led to a meaningful repricing across global rates markets.

Tentative signs of normalization?

While negotiations between the US and Iran remain ongoing, the ceasefire has allowed for lower spot oil prices; but forward oil prices have been edging still higher, reflecting concern for a prolonged oil market disruption. This has allowed for a recovery in risk assets but less so in rate expectations. Forward inflation rates have recently made new highs. Fed expectations remain elevated, reflecting a central bank that was already tilting more hawkish before the conflict began and that will need more convincing before resuming its easing path.

We err on the side of optimism, While the situation in the Middle East is always unpredictable, the base case is for a return to some kind of pre-war “status quo” with somewhat “normalized” energy prices. A more positive resolution, which includes elements of regime change, could even open the door to a sustained peace dividend and a broader easing of geopolitical tensions.

A more constrained Fed

Prior to the conflict, the Fed’s policy framework was relatively well understood. Since 2018, the Federal Open Market Committee (FOMC) has emphasized realized inflation and labor market outcomes, with policy designed to mitigate risks to employment. Rate cuts, when implemented, have typically been gradual and data driven. While that framework still holds, the backdrop has changed.

At the center of this shift is energy. Higher oil prices have reintroduced uncertainty into the inflation outlook at a critical moment. In March, CPI inflation came in at 3.3% year-over-year, driven by 10.9% spike in energy prices. Even if the direct impact proves temporary, the Powell Fed is unlikely to risk easing policy if inflation expectations appear at risk of drifting higher. In this environment, maintaining credibility becomes the priority. The result is a higher bar for rate cuts and a greater willingness to tolerate near-term economic softness.

Inflation beyond the shock

A critical question is whether the recent energy-driven price pressures are reflected in a lasting shift in inflation or are just a temporary disruption. Even before the conflict, there were indications that inflation could remain sticky, driven by residual effects from earlier explosive money supply growth and the ramifications of a weaker dollar.

However, current signals suggest that the direct impact may prove transitory. With forward inflation expectations stable, the risk that energy prices trigger a broader, sustained inflation cycle appears limited. This would give the Fed room, over time, to look through the shock.

Adding to the disinflationary case is the AI investment cycle, which is now well entrenched. Stronger productivity-led growth provides a structural tailwind for disinflation over time and, crucially, a forward-looking rationale for the Fed to support easing even before the last mile of inflation is won.

The path forward and a new Warsh Fed

Complicating the outlook is an evolving leadership backdrop. Now that the Department of Justice (DOJ) has dropped its criminal probe into the ongoing building renovations at the Fed, which could have delayed Chair Powell’s departure, we expect Warsh to make it through the nomination process and replace Powell as Fed Chair before the June meeting.

Warsh has a different approach to inflation, preferring to consider “underlying” trend inflation captured by trimmed mean estimates rather than the more traditional core PCE. Latest trimmed measures are tracking below 2 percent. Warsh is also a strong believer in AI-driven productivity growth, implicitly suggesting that growth can accelerate with little, if any, inflation risk. We think this predisposes him to advocating for further rate cuts in contrast to Powell.

Near term, the outlook for rates is closely tied to the trajectory of energy markets and the Iran conflict. A continued normalization would bring conditions closer to those that prevailed earlier in the year, when easing was a more immediate consideration. A deeper resolution to the conflict could accelerate that repricing further, with short rate tenors (2s & 5s) rallying the most, not just in the US but also Europe, where central bank tightening is currently priced. In Japan, the conflict has also muddied the waters for the BoJ’s rate normalization path. Normalization will allow this to get back on track.

In sum, for the US, the fundamental conditions for resuming easing are gradually falling into place: energy prices are showing signs of stabilizing, inflation expectations are anchored, and the structural case for disinflation remains intact. While the Fed will move carefully and later than markets might prefer, the direction of travel is less in doubt.

‍