The Fed's Impossible Arithmetic: Why Holding Rates Steady Is the Least Bad Option in the Hormuz Crisis

Six weeks ago, the U.S. economy was coasting. Inflation was trending toward 2%, the Fed had just cut rates three times in 2025, and markets were pricing in more easing ahead. Then, on February 28, the United States and Israel launched coordinated strikes on Iran, and the world changed. Iran closed the Strait of Hormuz. Roughly 20% of global oil and LNG supply¹ stopped flowing. Brent crude surged from around $80 to nearly $120 per barrel. The International Energy Agency called it "the largest supply disruption in the history of the global oil market." And just like that, every central banker's worst nightmare materialized: a massive inflationary shock they didn't cause and can't fix.

I want to work through why the standard playbook—hike rates to fight inflation—would make this crisis worse, not better. And why the bond market is already telling us something that policymakers need to hear.

The numbers, first. The March CPI report² showed headline inflation jumping to 3.3%, up from 2.4% in February—the highest reading since May 2024. The spike was overwhelmingly driven by energy: gasoline prices surged 21.2% in a single month, the largest one-month leap in decades. But here's the critical detail that separates this from a genuine inflationary spiral: core inflation, which strips out food and energy, came in at 2.6%², actually lower than economists expected. The disease is in one organ, not the whole body.

This distinction—headline vs. core—is not an academic curiosity. It is the single most important variable for deciding what the Fed should do next. When inflation is driven by excess demand (too much money chasing too few goods), rate hikes work by cooling that demand. When inflation is driven by a supply shock—a physical reduction in the availability of a critical input—rate hikes don't restore the missing barrels. They just pile a second wound on top of the first: households paying more for gasoline and facing tighter credit, businesses absorbing higher input costs and higher borrowing costs simultaneously. You're treating a broken leg with chemotherapy.

The Dallas Fed published a working paper³ in March that modeled exactly this scenario. A one-quarter closure of the Strait would reduce global GDP growth by an annualized 2.9 percentage points in Q2. If it lasts three quarters, global growth takes a 1.3 percentage point hit for the full year, and oil hits $167 per barrel. Their research also examined inflation expectations specifically, and found that supply shocks of this kind have relatively limited impact on long-term expectations⁴, with one-year expectations rising by at most 0.8 percentage points even in severe scenarios. This is not 1979.

And the bond market is confirming this. This is where the argument gets really interesting. An economics blog that tracks breakeven rates⁵ found that since February 27, the five-year breakeven inflation rate rose just 15 basis points to 2.55%—a modest move given that oil nearly doubled. But the five-year, five-year forward rate—the market's best estimate of where inflation will be five to ten years from now—actually fell 3 basis points to 2.07%. Let me say that again: the market's long-run inflation expectation dropped despite the largest oil supply disruption in history. The 10-year Treasury yield did climb 33 basis points, but almost all of that increase (28 basis points) came from higher real yields and term premium, not inflation expectations. Markets are pricing this as a temporary, bounded shock—ugly in the near term, but not a structural shift in the inflation regime.

This matters enormously because the case for aggressive rate hikes rests entirely on the claim that long-run inflation expectations will become "unanchored" if the Fed appears passive. That is the lesson people draw from the 1970s, when Arthur Burns' Fed let expectations drift and Paul Volcker had to engineer a brutal recession (unemployment hit 10.8%) to re-anchor them. But the 1970s analogy is structurally misapplied here. As economists Alan Blinder and Jeremy Rudd documented, the 1970s supply shocks hit an economy already running hot from Vietnam War spending and Great Society fiscal expansion—core inflation was above 4% before the 1973 OPEC embargo. Today's starting conditions are categorically different: core PCE was at 2.8% before the war, and the labor market, while near full employment, is in a "low-hire, low-fire" holding pattern, not an overheating spiral.

So what should the Fed actually do? The answer, I think, is roughly what it's doing right now—hold steady and wait—but with an important addition. The Fed held rates at 3.5%–3.75% at its March meeting⁶, and Chair Powell said the central bank did not yet need to raise rates, noting that longer-run expectations remained stable. The FOMC minutes revealed deep division⁶, with some officials raising the possibility of rate increases while others still favored eventual cuts. Cleveland Fed President Beth Hammack told the Associated Press⁷ she "could see where we might need to raise rates if inflation stays persistently above our target." That conditional framing is exactly right.

The optimal approach is what I'd call conditional hawkishness: hold rates steady, but issue explicit, specific forward guidance that the Fed will hike aggressively if (1) core services inflation accelerates above a stated threshold for consecutive months, or (2) measures of long-run inflation expectations—the 5y/5y breakeven, the University of Michigan survey—show persistent de-anchoring. This is not passivity. It is a demonstrated willingness to act, calibrated to the actual threat rather than the headline scare.

The strongest counterargument to my position is the insurance argument: even if the probability of expectations de-anchoring is low, the cost if it happens is catastrophic (think Volcker-scale recession), so the expected value of preemptive tightening is positive. I take this seriously. The commitment-mechanism logic—that forward guidance is only credible if backed by demonstrated willingness to hike—is real. But this argument works best when the insurance policy is cheap. Right now, it isn't. The U.S. economy posted only 0.5% GDP growth in Q4 2025 (final revision). The labor market shed 92,000 jobs in February⁸ before the war even started. Raising rates into an economy already on the edge of contraction, during a supply shock that monetary policy cannot fix, risks tipping the patient from "sick" to "critical" for no diagnostic benefit.

The situation is even more precarious across the Atlantic. The Bank of England held at 3.75%¹³ in March, but traders are now pricing in four rate hikes in 2026¹⁴. The UK imports around 40% of its oil and up to 60% of its natural gas. UK inflation is expected to breach 5%¹² this year. If the BoE hikes aggressively into an economy already growing at essentially zero with 5.2% unemployment, the UK faces a recession that rate cuts will then have to fix—a policy whiplash that destroys credibility more surely than holding steady would.

The deeper point here is that this crisis is not primarily a monetary policy problem. It is a geopolitical and energy security problem. The variable that determines whether inflation stays elevated or fades is not the fed funds rate. It is whether the Strait of Hormuz reopens⁹. As of today, that remains deeply uncertain: the ceasefire talks in Pakistan failed to produce a permanent deal¹¹, control of the strait remains the central sticking point, and Iran continues to charge tolls and limit traffic. The U.S. Navy just sent two destroyers through as a signal of intent, but Iran warned of a "firm and forceful response"¹⁰ to any military ships.

Here is what to watch in the weeks ahead. The April 28-29 FOMC meeting will be the most consequential since March 2020. The key indicator is not headline CPI—that will be ugly and everyone knows it. The indicators that matter are (1) the 5y/5y forward breakeven: if it moves above 2.3%, the expectations-anchoring story weakens and the case for hikes strengthens significantly; (2) core services inflation in the April and May CPI prints: if it accelerates above 3.5% annualized, second-round effects are materializing; and (3) the April jobs report: if the labor market deteriorates further, the case for hikes becomes economically untenable regardless of inflation data. I expect the Fed to hold again at the April meeting. If the strait reopens meaningfully by June, this episode will be remembered as a scare that the Fed correctly weathered by keeping its nerve. If it doesn't—if oil stays above $120 into summer and core inflation starts climbing—then the Fed will be forced into what several officials are already calling a "defensive hike," and we will be in genuinely uncharted territory.