The Strait of Hormuz in the Middle East is a critical choke point through which 20% of the world’s oil flows daily. The US and Israel attack on Iran and its retaliation has effectively shut that corridor down. To unlock the bottleneck, US President Donald Trump has offered a naval escort for oil tankers, with the US International Development Finance Corp. insuring ships. Consequently, crude oil prices (West Texas Intermediate, or WTI) spiked nearly 70% since their five-year low of US$55 per barrel in mid-December to a two-year high of US$94 on Monday. Lagging gasoline prices have risen 24% from a five-year low of US$2.80 per gallon in mid-January to an 18-month high of US$3.48 on Monday.
Financial market response
The volatility index (VIX) more than doubled from 13 last December to an oversold 29 last week, as many unnerved investors opted to shoot first and ask questions later. To wit, how long will this military campaign last and what will be the impact on inflation and Federal Reserve (Fed) policy? The S&P 500 has been relatively sanguine to date, declining by about 4% over the past month. But benchmark 10-year Treasury yields have been more troubled. They initially experienced a massive flight-to-safety rally, with yields falling from 4.30% in mid-January to 3.92% in late February. Last week, however, yields rose sharply to 4.13%, as fixed-income investors seem concerned about a spike in inflation.
How long will the Iran war last?
No one knows, while President Trump originally said it might last several weeks, he mentioned on Monday that it could be over soon. According to Goldman Sachs, however, investors expect it could conclude by the end of March, given the military superiority of the US and Israel and the support of the major oil-producing nations in the Middle East. Some bearish forecasts breathlessly expect crude oil to re-test the US$130 high during the early days of the Russia/Ukraine war in 2022. But it is conceivable that, without sustained supply disruptions, crude prices could recede to US$65 per barrel in coming months.
The US is the largest oil producer in the world, extracting around 13.7 million barrels per day. OPEC recently announced it will collectively add 206,000 barrels per day starting in April. The US Strategic Petroleum Reserve (SPR) sits about 58% full at 415 million barrels, but President Trump has no current plans to tap it.
What about inflation?
The Core Consumer Price Index (CPI), which strips out volatile energy and food costs, has moderated from a 40-year high of 6.6% year-over-year (y/y) in 2022 to a nearly five-year low of 2.5% in January 2026, in the US. February is expected to decline further to 2.4%. To be sure, nominal inflation (now at 2.4% y/y in January 2026) could rise in coming months due to the spike in energy prices, but we expect that increase would be short lived.
Fed leadership and policy transition
Although President Trump recently sent his nomination of Kevin Warsh to the Senate Banking Committee for review, Republican Senator Thom Tillis. said that the committee will not consider him until the Justice Department’s criminal investigations into Chair Jerome Powell and Board of Governor member Lisa Cook are dismissed or completed. We expect Warsh will clear the Senate before Powell’s term as Fed chair expires on 15 May. However, Powell has not announced if he will remain on the board after that, which he could do until January 2028.
The Iran war, the spike in oil prices and the potential for a surge in inflation complicate expectations for additional interest rate cuts.
The Iran war, the spike in oil prices and the potential for a surge in inflation complicate expectations for additional interest rate cuts. The Warsh Fed would likely take a wait-and-see approach. But with the upper band of the fed funds rate at 3.75% and nominal CPI inflation at 2.4%, the Fed has plenty of room to reduce rates to a terminal value of around 3% over time. Alternatively, the spike in oil prices might elevate investors’ fear that inflation could sustain a higher level. A logical conclusion would argue that policymakers could shift gears to hike rates.
Other than that, Mrs. Lincoln, how did you enjoy the show?
Aside from heightened geopolitical risk, the underlying US economic fundamentals are solid. Productivity is soaring, averaging nearly 4.1% over the last three quarters of 2025. That’s more than double the 1.9% average productivity gain in the country over the last half century.
ISMs are soaring
Both ISM indices so far this year are stronger than expected. The manufacturing index hit a three-year high in January at 52.6. Complementing this, five of the six regional Fed indices accelerated over the past several months. Also, capital good shipments, non-defence ex-air, have surged over the past four months. What of services? The ISM nonmanufacturing index hit a nearly four-year high in February at 56.1. Lastly, the ISM business activity index accelerated to a nearly two-year high of 59.9 in February.
Revenue and profit growth accelerating
The S&P’s fourth-quarter reporting season is nearly complete, and results are stronger than expected. Revenues rose 9.3% y/y in the fourth quarter of 2025 (consensus gain of 7.7% expected), compared with gains of 8.4% in the third quarter, 6.4% in the second quarter and 4.8% in the first quarter. Earnings increased 14.1% y/y in the fourth quarter of 2025 (consensus gain of 8.3% expected), versus gains of 13.4% in the third quarter, 11.9% in the second quarter and 13.1% in the first quarter. Net profit margins increased in the fourth quarter, due to the improvement in productivity and the moderation in wages. Technology, industrials and cyclicals were the stars.
The initial measure of fourth quarter 2025 GDP was a weaker-than-expected increase of only 1.4% quarter-over-quarter. That pales in comparison to robust third- and second-quarter gains of 4.4% (the strongest quarterly growth in two years) and 3.8%, respectively. The record 43-day federal government shutdown last October and November reduced GDP by 1.15 percentage points, and the core private final domestic sales component rose 2.4%.
Looking through the fog of war
The liquidity, equity and fixed income investment professionals who comprise Federated Hermes’ macroeconomic policy committee met last Wednesday to discuss the many elements facing the US and world.
- We expect a rebound in federal government spending in the first quarter of 2026 to offset a disappointing Christmas shopping season, brutal winter weather and a small 2.8% Social Security benefit adjustment in January. We raised our forecast for first quarter of 2026 GDP growth from 3.0% to 3.1%, while the Blue-Chip consensus raised its from 1.9% to 2.0% (within a range of 0.7% to 3.1%). The Atlanta Fed’s GDPNow is at 3.0%.
- The fiscal stimulus from President Trump’s One Big Beautiful Bill should result in larger-than-normal tax refunds, and an early Easter should help to spark stronger consumer spending in March. We kept our forecast for second quarter of 2026 GDP growth unchanged at 2.9%, while the Blue-Chip consensus also left its estimate unchanged at 1.9% (within a range of 0.8% to 2.7%).
- We still expect manufacturing, construction and employment to improve over the summer months, and we left our forecast for third quarter of 2026 growth unchanged at 3.0%, while the Blue-Chip consensus kept its projection at 2.0% (within a range of 1.3% to 2.6%).
- We increased our estimate for fourth quarter of 2026 growth from 2.9% to 3.0%, while the Blue-Chip consensus raised its from 2.0% to 2.1% (within a range of 1.4% to 2.6%).
- As a result, we raised our estimate for full-year 2026 growth from 2.9% to 3.0%, while the Blue Chip consensus call increased from 2.1% to 2.4% (within a range of 1.6% to 3.0%).
- We left our year-end 2026 estimate for core CPI inflation unchanged at 2.5%, while the Blue Chip consensus lowered its forecast from 2.8% to 2.7% (within a range of 2.4% to 3.1%). But we raised our year-end 2026 estimate for the core Personal Consumption Expenditures (PCE) inflation from 2.4% to 2.5% (compared with Core PCE inflation of 3.0% in December 2025), while the Blue Chip left its projection at 2.7% (within a range of 2.4% to 3.1%).
- We initiated our full-year 2027 GDP growth estimate at 3.1%, while the Blue-Chip consensus is calling for 2.1% (within a range of 1.7% to 2.5%).
- We initiated our year-end 2027 estimate for core CPI inflation at 2.4%, while the Blue-Chip consensus is at 2.5% (within a range of 2.1% to 3.0%). Lastly, we initiated our year-end 2027 estimate for core PCE inflation at 2.3%, identical to the Blue-Chip consensus estimate (within a range of 2.0% to 2.9%).
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