Morgan Stanley's global head of fixed income research, Andrew Sheets, has indicated that if Federal Reserve policymakers deem interest rate hikes necessary this year, they are likely to downplay the price impact of the Iran conflict.
Speaking on Thursday, Sheets stated, "Our judgment is that the Fed will choose to look through this. The Fed is more likely to view it as a growth shock rather than an inflation shock. Therefore, we do not believe this will likely become a factor prompting the Fed to raise interest rates."
This assessment presents a subtle contrast to current mainstream market expectations. Since Iran's closure of the Strait of Hormuz—which prior to the conflict handled about one-fifth of global oil and gas shipments—world energy prices have surged significantly. Crude oil prices have surpassed $120 per barrel, and U.S. retail gasoline prices have reached multi-year highs, directly pushing up overall inflation.
However, Sheets believes the Fed's structural analytical framework would treat energy price increases driven by geopolitical conflict as a "temporary supply shock," not a demand-driven, persistent inflation, and thus would not tighten policy in response.
The rising costs have already prompted some Fed officials to suggest that rate hikes in 2026 may be needed to help contain inflation pressures. Market sentiment has undergone a dramatic reversal in just a few weeks. Right before the Iran conflict erupted, traders widely expected the Fed to implement more than two rate cuts this year. Now, based on interest rate futures pricing, the market sees the probability of at least one Fed rate hike by year-end has risen to about two-thirds.
Inflation data continues to exceed targets—the core Personal Consumption Expenditures (PCE) price index year-on-year increase remains around 2.8%, well above the Fed's 2% policy goal. Sheets noted that core inflation measures are "significantly above the Fed's target." He added, "Heading into the second half of the year, I think the concern is warranted that the Fed has accomplished its mission on employment but not on inflation."
Key Inflation Drivers: Fiscal Stimulus, Credit Expansion, and AI Investment
It is worth noting that Sheets views the Iran conflict as not the primary driver of current inflation. He points to three more fundamental factors: first, ongoing loose fiscal policy in the U.S. (including tax cuts and spending bills from the previous administration); second, accelerated bank loan growth and easing credit conditions; and third, massive corporate investment in artificial intelligence infrastructure, driving related demand for electricity, equipment, and construction.
These structural factors exert a more persistent upward pressure on prices than geopolitical conflict. Despite this, Morgan Stanley's baseline forecast remains relatively optimistic. Sheets stated, "We expect inflation to improve somewhat in the second half of the year." He also believes the labor market will remain volatile, "there is enough uncertainty to keep the Fed on hold this year, and then open the door for rate cuts next year—in our baseline scenario, there will be several cuts next year."
"We do believe inflation will come down," he said. The labor market will stay choppy, "there is enough uncertainty to keep the Fed on hold this year, and then open the door for next year—in our view, the baseline scenario—for rate cuts."
Nevertheless, policymakers are growing increasingly concerned. Dallas Federal Reserve President and current FOMC voting member Lorie Logan said on Wednesday that while the U.S. labor market is "broadly balanced," inflation does not appear to be returning to the Fed's 2% target. Speaking at an event in El Paso, Texas, Logan stated, "I am increasingly concerned that it may be necessary to raise rates later this year to fully restore price stability and appropriately balance both sides of the Fed's dual mandate."
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