The trajectory of oil prices, determined by developments in Iran, is directly influencing Federal Reserve policy. Deutsche Bank has outlined three potential scenarios: 1. A peace deal is reached, alleviating near-term pressure for rate hikes; 2. Negotiations break down, leading to a stalemate where high oil prices push up inflation, with the greatest risk of rate hikes in 2026; 3. Conflict escalates, causing oil prices to surge and presenting the Fed with a two-way risk of either hiking or cutting rates. Currently, the market should be most wary of the second scenario.
The direction of the Iran situation and the outlook for Federal Reserve monetary policy are emerging as the two most critical factors influencing global markets. Deutsche Bank's economic research team, in a recent report, systematically analyzed the potential impact on the Fed's policy path based on three possible outcomes of the Iran ceasefire negotiations—from a fading of near-term hike risks, to multiple hikes in 2026, to two-way uncertainty in policy direction. Each scenario corresponds to a distinct market logic.
The analysis notes that the path of oil prices will directly affect the anchoring of inflation expectations, thereby determining whether the Fed needs to restart rate hikes. In the bank's view, the most concerning scenario at present is not the most extreme case of escalating conflict, but the intermediate state of "failed negotiations and a stalemate." In this scenario, persistently high oil prices would most likely force the Fed to take substantive tightening action in 2026.
Recent geopolitical developments show some progress in negotiations to extend the ceasefire and reopen the Strait of Hormuz, with markets already reacting optimistically. Brent crude futures have fallen below $100 per barrel, touching a near one-month low, and the 10-year U.S. Treasury yield has also retreated significantly, erasing most of its gains from the past week. However, uncertainties remain in the negotiation details, with core disputes such as Iran's nuclear program unresolved.
Scenario One: A Peace Deal is Reached – Near-term Hike Pressure Eases, but Medium-term Risks Linger In Deutsche Bank's first scenario, a breakthrough in negotiations leads to the reopening of the Strait of Hormuz. Oil prices continue their recent downtrend but remain above pre-conflict levels. U.S. Treasury yields fall further, and risk asset markets strengthen overall as tail risks dissipate, leading to easier financial conditions.
In this context, pressure on the Fed to hike rates at upcoming meetings would ease notably. With headline inflation softening and short-term inflation expectations receding, Fed officials would likely view recent core inflation pressures as temporary disturbances from the energy price shock, choosing to "look through" them rather than respond immediately. Deutsche Bank expects new Fed Chair Warsh to reinforce this inclination.
However, the bank also warns that the baseline narrative of "inflation not being persistent" takes time to be disproven, and hike risks do not vanish. If the labor market remains tight, inflation expectations move higher, or inflation remains stubbornly high even after tariff and energy pressures fade, the risk of policy rate increases would be more likely to materialize in 2027.
Scenario Two: Negotiations Break Down, Stalemate Ensues – Highest Hike Risk in 2026 Deutsche Bank characterizes the second scenario as having the "highest hike risk" among the three. In this case, peace talks fail, the Strait of Hormuz remains closed long-term, but conflict does not escalate further. Oil prices stay elevated rather than surging sharply.
Persistently high oil prices would more significantly feed into core inflation and pose a greater risk of unanchoring inflation expectations. Simultaneously, oil prices in this scenario would likely not be high enough to severely damage demand and force the Fed to shift its focus to the labor market. This means the Fed would face one-sided inflation pressure without the justification to "stand pat due to an economic downturn."
The bank believes the Fed is unlikely to take hike action before its September meeting—a policy pivot would require steps such as removing the easing bias (June), some officials publicly discussing hike possibilities (July-September), and committee consensus-building.
But it also notes that recent comments from Fed Governor Waller, suggesting hikes might be appropriate if "inflation does not fall back soon enough," indicate the Fed's potential willingness to tighten policy more swiftly. Therefore, the possibility of multiple hikes in 2026 should not be ruled out.
Scenario Three: Conflict Escalates Again – Two-way Risk for Policy Outlook The third scenario envisions a renewed escalation in Iran tensions, leading to a more substantial and sustained surge in oil prices. Deutsche Bank believes this scenario does not necessarily mean the Fed will unilaterally move toward hikes; instead, it introduces two-way uncertainty to the policy outlook.
On one hand, escalating conflict would drive a larger and more persistent rise in headline inflation, with core inflation facing more significant pass-through risks. The likelihood of inflation expectations becoming unanchored would rise tangibly. The Fed would then need clear policy communication to signal its willingness to tighten policy to address price stability risks.
On the other hand, a large and sustained oil price increase would raise the risk of non-linear shocks to the real economy, eventually affecting the labor market.
Deutsche Bank points out that consumers can currently bear energy prices near current levels, with tax cut policies somewhat offsetting the pressure from rising oil prices. However, if oil and gas prices rise substantially further, this buffer would be exhausted. At that point, the labor market could slip from its current fragile equilibrium of "low hiring, low layoffs," leading to further demand contraction or an eventual wave of layoffs.
In this scenario, the Fed's ultimate policy stance would depend on the sequence in which these two risks materialize: if the economy remains resilient while inflation expectations become unanchored first, forceful tightening would be needed. If cracks appear in the labor market first, the Fed might instead lean toward rate cuts, citing prospective easing of price pressures.
Synthesizing the three scenarios, Deutsche Bank's analytical framework reveals a clear logical chain: the Iran situation determines the oil price trajectory, which in turn determines the nature and duration of inflation pressure, and whether inflation expectations become unanchored ultimately decides the Fed's policy space.
Key signals to watch currently include: substantive progress in ceasefire talks, whether Brent crude can stabilize below $100 per barrel, and changes in rhetoric from Fed officials in upcoming meetings—particularly whether they begin removing the easing bias or if officials start publicly discussing hike possibilities. These signals will be crucial observation windows for assessing the probability distribution of the three scenarios above.
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