There is a reflex in financial markets that activates every time oil prices spike: the assumption that the Federal Reserve must respond by raising interest rates or at least holding them higher for longer. It happened in 1973. It happened in 1979. It happened again in 2022 when Russia invaded Ukraine. And now, with Brent crude approaching $120 a barrel following the closure of the Strait of Hormuz, the same instinct is asserting itself — and for the same reason it was wrong before, it deserves serious pushback.
The argument is worth making plainly: when oil prices rise because of a geopolitical supply shock rather than a demand boom, hiking interest rates is largely the wrong medicine. It doesn’t fix the supply problem. It doesn’t reopen a blocked shipping channel. What it does do — and quite effectively — is crush growth, raise unemployment, and heap more economic pain on an economy that is already being squeezed from the outside. The question is whether modern central bankers understand that distinction well enough to resist the political and market pressure pushing them in the wrong direction.
What Kind of Inflation Is This?
The starting point is understanding what kind of inflation we’re actually dealing with. The March 2026 CPI print came in at 3.3% year-on-year — up sharply from 2.4% in both January and February. The energy index surged 10.9% in a single month, its largest monthly jump since September 2005. Gasoline prices climbed from $2.98 per gallon on the day before the Iran war began to $4.15 — a 39% increase in roughly six weeks, representing the fastest peacetime gasoline price shock in modern American history.
These are startling numbers. But here is the critical question: are they a reflection of an overheating economy — too much money chasing too few goods — or a reflection of a geopolitical supply shock that removed critical energy and commodities from global markets? The answer is clearly the latter. The Strait of Hormuz closure has stripped an estimated 12 to 15 million barrels per day from global supply, representing up to 15% of world output. That is not inflation born of excess demand. That is inflation born of war.
The distinction matters enormously for monetary policy. Interest rate increases are a demand-side tool. They work by making borrowing more expensive, slowing consumer spending, cooling the housing market, and damping corporate investment. None of those mechanisms address a supply disruption in the Persian Gulf. Raising rates does not reopen the Strait of Hormuz. It does not replace damaged Qatari LNG infrastructure. It does not bring idle tankers back through Iranian-controlled waters.
Bloomberg columnist Jonathan Levin made this point directly in early March, writing that while the 1970s and 2022 shocks supercharged U.S. inflation, a sustained conflict with Iran would primarily hit the American economy through slower growth. Modern central bankers, he argued, know to look through supply-driven energy price volatility when adjusting policy rates — and rising bond yields reflected markets potentially misjudging how the Fed would actually respond.
The Growth Side of the Equation
Here is what the rate-hiking narrative consistently underweights: the economic damage that a severe energy shock does to growth and employment. The same oil prices that are driving up CPI are also draining consumer wallets, compressing corporate margins, and dragging on economic activity in ways that naturally slow inflation by reducing demand.
The evidence is already accumulating. Analysts have cut 2026 consumer staples earnings growth forecasts from 7% to just 2.2%. Nike has warned of a quarterly sales decline of up to 4%. Conagra has trimmed its full-year earnings outlook. Gasoline at $4.15 a gallon is costing the average American driver an additional $600 per year — money that would otherwise be spent elsewhere in the economy. The Federal Reserve Bank of Dallas has modelled that a closure of the Strait of Hormuz removing close to 20% of global oil supplies could lower global real GDP growth by an annualised 2.9 percentage points in the second quarter alone.
The IMF has similarly warned that the conflict is a major supply shock that tests a world with limited fiscal buffers. Every 10% increase in oil prices, the IMF estimates, reduces annual global GDP growth by roughly 0.15 percentage points and adds 0.4 percentage points to inflation in the following year. The two effects work in opposite directions — higher prices and weaker growth — creating exactly the stagflationary pressures that make monetary policy so difficult to calibrate. Raising rates into that environment risks tipping a slowing economy toward recession without solving the inflation problem, because the inflation is not caused by the thing rates can control.
What Markets Are Getting Wrong
Markets have already begun pricing in a more hawkish Fed trajectory. Before the March CPI report, markets expected at least two rate cuts in 2026. That expectation has now been slashed to one, with some forecasters — including Commonwealth Bank — projecting that the Fed will actually begin raising rates again from late 2026, adding around 75 basis points of tightening.
That repricing may be premature. Oxford Economics lead U.S. economist Bernard Yaros cautioned: “Despite the temptation to compare to the last major geopolitical episode, this isn’t 2022.” The 2022 energy shock was layered on top of an already overheated economy, pandemic-era stimulus still washing through the system, and labour markets that were running unsustainably hot. The 2026 context is different: the labour market, while still relatively solid, is more brittle than it was four years ago, and the supply shock — however severe — is geographically and causally specific in a way that 2022’s broad commodity inflationary episode was not.
Morgan Stanley, notably, has maintained its expectation that the Fed will still cut rates in 2026, projecting two 25-basis-point reductions in the second half of the year. The bank’s analysts note that while one-year inflation expectations have picked up in response to energy prices, long-run inflation expectations — the metric the Fed watches most carefully as a signal of whether inflation is becoming entrenched — have remained near pre-pandemic levels. That is an important indicator. It suggests that consumers and businesses do not yet expect this shock to become the new baseline, which is precisely the condition under which a central bank can afford to look through headline inflation rather than tightening aggressively against it.
Morgan Stanley also made a point that often gets lost in the rate debate: financial conditions have already tightened significantly since the onset of the conflict. The combined impact of a stronger dollar, higher oil prices, and rising equity risk premiums is equivalent to roughly an 80 basis point rate hike in economic effect. In other words, the market has already done some of the Fed’s work for it.
The Lesson Central Banks Keep Relearning
The painful history of the 1970s casts a long shadow over every oil shock discussion. The argument for aggressive rate hikes typically points to that era, when central banks allowed energy-driven inflation to become entrenched and ultimately had to inflict severe recessions to bring it back under control. It is a legitimate historical warning, and it should not be dismissed.
But the lesson is not simply “always raise rates when oil prices spike.” The deeper lesson is: distinguish between inflation that reflects fundamental excess demand and inflation that reflects a temporary, externally imposed supply disruption. Paul Volcker raised rates to 20% in 1980 because inflation had become deeply embedded in wage expectations and price-setting behaviour across the economy — not simply because oil was expensive. That broad entrenchment of inflation is what today’s long-run inflation expectations, still well-anchored, suggest has not yet happened.
The Fed held rates unchanged at its March meeting, keeping the federal funds rate at 3.5% to 3.75%. That was the right call. The door to rate cuts later in the year was left open for a reason: because the Fed understands, at least in principle, that geopolitical supply shocks require diplomatic and military solutions, not monetary ones. Raising interest rates to fight an oil shock caused by a war in the Middle East does not reopen shipping lanes. It just makes a painful situation worse for American workers and businesses who had nothing to do with starting it.
Written by Shalin Soni, CMA specializing in financial analysis, global markets, and corporate strategy, with hands-on experience in financial planning and analytical decision-making.
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Source: Based on The Wall Street Journal and publicly available information.
Disclaimer
This article is based on publicly available information, market developments, and credible media reports. The content is intended for informational and analytical purposes only and should not be considered financial, investment, or legal advice.