Federal Reserve Decision Preview: How Will the U.S.-Iran Situation Impact Economic Outlook? Will the Dot Plot Undergo Major Changes?

What challenges does the Federal Reserve face in its rate cut decision amid stagflation risks?

On Tuesday, March 17, local time, a two-day Federal Reserve policy meeting officially began in Washington, D.C.

This is the first meeting since the U.S. launched airstrikes against Iran. The airstrikes caused oil prices to surge, affecting various asset classes. Fed officials will focus on examining the impact of energy shocks on inflation and economic growth. The latest federal funds rate futures pricing shows market expectations for rate cuts this year have been reduced to one.

Economic Forecasts

At this meeting, the Fed will update its first economic outlook summary (SEP) of the year. SEP is a quarterly forecast report released by all 19 Fed officials (including 12 FOMC voting members), covering key economic variables: GDP growth, unemployment rate, inflation, and median interest rate. This forecast will reflect how the Federal Open Market Committee (FOMC) assesses the short-term, medium-term, and long-term impacts of the U.S.-Iran conflict.

A summary by First Financial reporters indicates that mainstream Wall Street views expect the Fed to slightly lower its 2026 growth forecast, reflecting energy and tariff pressures. Inflation is expected to be revised upward, considering the rise in oil prices due to Middle East tensions. The unemployment rate is expected to remain stable or slightly increase, and the median interest rate is expected to rise, indicating a reduced expectation for rate cuts.

The market shock caused by the war is not just about rising gas prices at the pump. Disruptions in the global oil supply chain could last for months, indirectly pushing up core inflation through freight, air travel, and commodity prices, which are the Fed’s preferred inflation indicator, the Personal Consumption Expenditures (PCE) price index. If the stock market continues to decline, high-income households’ consumption may decrease, further hampering economic recovery.

Gregory Daco, Chief Economist at EY-Parthenon, wrote in a report: “The Middle East conflict will leave a clear mark on the U.S. economy through rising energy prices, tightening financial conditions, increased uncertainty in the private sector, and renewed supply chain pressures.”

Concerns about stagflation have intensified. Beth Ann Bovino, Chief U.S. Economist at U.S. Bank, stated: “The Middle East conflict, combined with the latest employment report, makes the Fed’s job more difficult. The situation is starting to look more like stagflation — that is, we may face higher inflation alongside weaker growth.”

Even the mere prospect of stagflation could put the Fed in a dilemma: further rate cuts to boost employment might push inflation higher. Chicago Fed President Austan Goolsbee said this month: “Stagflation is always the worst-case scenario for a central bank because there are no obvious monetary policy solutions.”

Interest Rate Outlook

Last September, the Fed resumed rate cuts to support a weakening labor market, but in January this year, given easing employment and inflation risks, the Fed paused its easing cycle. Investors previously expected more rate cuts this year, which was generally seen as supportive of stocks and other assets. However, concerns that rising oil prices will push inflation higher have led markets to lower their expectations for rate cuts.

Even before the Middle East tensions escalated, the Fed was already caught between risks on both sides of employment and inflation. Officials have divergent views on the rate cut outlook for 2026. The minutes from the January meeting show significant opposition within the Fed to further rate cuts. Officials like Boston Fed President Susan Collins and Cleveland Fed President Bess Harkey stated that weak employment data had not changed their view — rates could remain unchanged for quite some time.

Stephen Stanley, Chief Economist at Santander Bank, said that after the last meeting, the Fed had already ruled out a rate cut in March. The Middle East conflict “currently causes the Fed to remain on hold.”

Derek Holt, Head of Capital Markets Economics at Scotiabank Canada, predicts that at this meeting, officials more concerned about inflation will be uneasy, while others focusing on the deteriorating employment situation will be less so. These views will offset each other “until the extent and duration of energy shocks and worsening employment become clearer,” he said.

CME FedWatch tool shows that the market has pushed back the first 25 basis point rate cut from June to December. Most forecasts now project only one rate cut in 2026, with the rate center moving higher, signaling expectations of higher and more persistent inflation.

Mainstream institutions have some disagreement on the rate outlook. Goldman Sachs expects the Fed to cut rates by 25 basis points in September and December, citing rising inflation risks from the Iran war. Previously, they anticipated rate cuts starting in June, with another in September. Barclays has delayed the first rate cut until September, expecting only one cut of 25 basis points this year. Morgan Stanley’s chief U.S. economist, Michael Gapen, said the Fed might “ignore” short-term energy price shocks, but risks are shifting toward “delayed and larger cuts” if economic activity weakens. Beth Ann Bovino at U.S. Bank believes that if the conflict prolongs and oil risk premiums stay high, embedding inflation expectations, the Fed might even have to consider raising rates.

For Fed Chair Jerome Powell, this will be his second-to-last meeting before his term ends in May. The next rate adjustment may only occur after former Fed Governor Kevin Warsh — Trump’s nominee for Fed Chair — officially takes over the central bank.