Five weeks into the U.S.-Israeli war with Iran, the Federal Reserve faces a test of monetary credibility it has not encountered in decades. Oil prices have surged more than 50% in four weeks, pushing global crude to around $110 a barrel and driving U.S. gasoline prices toward a national average of $4 a gallon. The resulting jump in consumer inflation expectations — the largest single-month increase since April 2025 — has rattled bond markets, produced two consecutive weak Treasury auctions, and prompted increasingly hawkish language from Fed officials. Chair Jerome Powell has characterised the current stance as “wait and see,” noting that longer-term inflation expectations remain reasonably anchored. But multiple Fed officials — including Governor Michael Barr and Philadelphia Fed President Anna Paulson — have issued pointed warnings that the repeated succession of price shocks since the pandemic may be eroding the foundation of public trust on which effective monetary policy depends. Market pricing has moved accordingly: interest rate cuts have been fully priced out, and traders are now betting on the possibility of a rate hike later in 2026.
Key Overview
- Oil prices rose more than 50% in four weeks after the U.S.-Israeli war with Iran began on February 28, 2026
- Global crude oil has settled at approximately $110 a barrel, with U.S. gasoline approaching $4 a gallon nationally
- The University of Michigan’s final March consumer sentiment index fell to 53.3 — its lowest since December 2025
- One-year inflation expectations jumped from 3.4% in February to 3.8% in March — the largest monthly rise since April 2025
- Five-year inflation expectations held at 3.2%, still above the pre-pandemic range of 2.3–3.0%
- Two consecutive weak Treasury auctions — a $69 billion two-year note sale and a $70 billion five-year sale — signalled investor concern about inflation persistence
- The Fed held its benchmark rate steady at 3.50%–3.75% at its March 18 meeting
- Updated Fed projections placed full-year inflation at 2.7%, up from earlier estimates
- Markets have fully priced out Fed rate cuts for 2026 and are pricing in the possibility of a hike
- Fed Governor Barr warned that the energy shock could lift longer-term inflation expectations if it persists
- Powell said the Fed is inclined to look past the oil shock but acknowledged the cumulative risk of five years of above-target inflation
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The Fragility Beneath the Surface
For much of the post-pandemic period, the Federal Reserve took quiet comfort in one critical statistic: longer-term inflation expectations, as derived from financial market instruments and consumer surveys, remained close to the Fed’s 2% target. That stability — often described as inflation expectations being “anchored” — was taken as evidence that the public retained faith in the Fed’s commitment to price stability, even through several years of above-target inflation. It meant the Fed could respond to shocks without panicking, confident that its credibility was intact.
That comfort is now under pressure. With oil prices up more than 50% in four weeks following the outbreak of the U.S.-Israeli war with Iran on February 28, 2026, the Fed faces a new price shock arriving on top of a post-pandemic inflation legacy that has never fully resolved. “Long-term inflation expectations are consistent with 2%, but they may also be a little more fragile,” Philadelphia Fed President Anna Paulson said at a San Francisco Fed conference on March 28 — an unusually candid acknowledgment from a senior official that the anchor may be shifting.
The war has driven global oil prices to around $110 a barrel, sending gasoline prices surging to a national average approaching $4 a gallon. Airfares and other energy-intensive prices are expected to follow. The compounding effect on households already wary of inflation after years of elevated prices is showing up in both consumer surveys and financial markets — and the Fed is watching every signal.
What the Data Is Saying
The clearest evidence of shifting expectations came in the University of Michigan’s final March 2026 consumer sentiment survey, released on March 27. The headline sentiment index fell to 53.3 — its lowest reading since December 2025 — down from 55.5 in the preliminary reading and 56.6 in February. The deterioration was broad-based, with declines across age groups, income levels, and political affiliations.
Most concerning for the Fed was the inflation expectations data embedded in the survey. One-year inflation expectations climbed from 3.4% in February to 3.8% in March — the largest one-month increase since April 2025. The survey’s director noted that year-ahead gasoline price expectations rose to their highest level since June 2022, when inflation peaked in the aftermath of Russia’s invasion of Ukraine. The current reading remains well above the 2.3–3.0% range that prevailed in the two years before the pandemic.
Critically, two-thirds of the March survey’s interviews were conducted after the conflict with Iran began on February 28, and those post-conflict respondents showed notably higher inflation expectations for both near- and longer-term horizons — suggesting the oil shock is already feeding through to consumer psychology in real time.
The five-year inflation outlook held at 3.2%, edging down slightly from February’s 3.3%. This longer-term measure is the one Fed policymakers track most closely as a gauge of expectation anchoring, and for now it remains within the upper range of 2024 readings. But it sits persistently above the sub-2.8% levels that were standard before the pandemic, and the trajectory has central bankers on alert.
Bond Markets Flash a Warning
Consumer surveys are not the only place where inflation anxiety is registering. Bond markets delivered two notable signals in the same week that the Michigan data landed. A $69 billion sale of two-year Treasury notes on March 24 drew unexpectedly weak demand, with the final auction yield of 3.936% creating the largest “tail” — indicating higher yields were needed to attract buyers — since March 2023. The day after, a $70 billion five-year Treasury auction registered the second disappointing result of the week, marking the weakest demand since March 2025.
The two-year Treasury yield is often the benchmark most sensitive to monetary policy expectations, and its reaction was significant. Two-year yields rose by as much as 10 basis points to 3.96%, with analysts attributing the move to investors’ growing concern that the Iran war could re-ignite inflation and either delay or reverse any Fed rate cuts. “High oil prices are keeping the market pricing in a small chance of a Fed rate hike this year,” noted John Canavan, chief analyst at Oxford Economics.
The 2-year and 3-year Treasury yields spiked sharply through March, effectively uninverting the yield curve — a sign the market is pricing in stronger-than-expected inflation rather than the soft landing many had anticipated entering 2026. As oil prices advanced and troop deployments to the Middle East were reported, investors who might otherwise have sought safe-haven bonds instead demanded higher yields to compensate for the inflation risk they perceived.
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The Fed’s Dilemma: Look Through or React?
The core challenge facing the Federal Reserve is one that has no clean answer. Energy shocks are, by their nature, transitory supply disruptions. The standard monetary policy playbook — laid out in textbooks and central bank guidance alike — is to “look through” temporary price shocks rather than tighten policy in response to events that monetary tools cannot directly address.
Powell articulated this logic clearly in remarks to undergraduate economics students at Harvard University on March 30. “The tendency is to look through any kind of a supply shock,” he said. “But a critical, essential aspect of that is you have to carefully monitor inflation expectations.” He also pointed to the mechanics of policy transmission: “Monetary policy works with long and variable lags, famously, and so, by the time the effects of a tightening in monetary policy takes effect, the oil price shock is probably long gone.”
But Powell was equally clear about what would force a different calculus. “We’ve been coming down close to 2% post-pandemic, but we’ve never actually gotten and stayed at 2%,” he said. The Fed has now spent five years missing its inflation target to the upside, absorbing a pandemic price shock, a tariff shock, and now an energy shock from the Iran war. Each individually might be looked through; the cumulative weight of all of them together is harder to dismiss. “It’s a repeated set of things,” Powell said, “and you worry that’s the kind of thing that can cause trouble for inflation expectations. We worry a lot about that. We are very strongly committed to doing what it takes to keep inflation expectations anchored at 2%.”
At its March 18 meeting, the FOMC held rates steady at 3.50%–3.75% and issued updated forecasts projecting full-year inflation at 2.7% — up from earlier estimates. One governor, Stephen Miran, dissented in favour of a rate cut. The remaining scheduled FOMC meetings in 2026 fall in late April, June, July, September, October, and December — each of which could become a flashpoint depending on how the conflict evolves and whether energy prices relent.
Officials Sound the Alarm in Different Keys
The week of March 24–28 saw a notable escalation in the hawkishness of Fed communications, with several officials publicly expressing concern that this latest shock could be the one that tips expectations from fragile to broken.
Fed Governor Michael Barr was the most direct. In remarks prepared for a Brookings Institution event in Washington on March 26, Barr described the compounding nature of the inflation challenge in stark terms. “The longer inflation remains above 2%, the greater the risk that it becomes entrenched in expectations, making it harder to achieve the FOMC’s goal,” he said. On the Iran conflict specifically, he warned that if the war continues for some time, “the spike in energy prices and other commodities could have broader implications for both prices and economic activity.” Separately, Bloomberg reported that Barr had also said rates may need to hold steady for “some time” until there is sustainable evidence that goods and services inflation is retreating.
Meanwhile, Powell told the Harvard audience that the Fed’s current policy stance is “in a good place for us to wait and see how that turns out,” adding that the central bank is not yet at the moment when it needs to decide whether to formally look through the energy shock or respond to it. He noted the existing tension between the two mandates: “There’s sort of downside risk to the labor market, which suggests keep rates low, but there’s upside risk to inflation, which suggests maybe don’t keep rates low. You’ve got tension between the two objectives.”
The 1970s Shadow
No discussion of inflation expectations at the Federal Reserve happens without the shadow of the 1970s looming in the background. That decade saw a combination of oil shocks — first from the 1973 OPEC embargo, then from the 1979 Iranian revolution — interact with a Fed that was unwilling or unable to make a credible commitment to price stability. The result was a decade of double-digit inflation, followed by the punishing Volcker-era rate hikes of the early 1980s that engineered a severe recession to break the psychology of inflation.
The lesson central bankers took from that period is stark: once inflation expectations become unanchored — once firms and households stop believing that the central bank will do what it takes — the resulting wage-price spiral becomes exponentially harder to break. “Expectations are at the core of central bank policymaking,” said Ed Al-Hussainy, a fixed income and macro portfolio manager at Columbia Threadneedle, noting that credible promises to control inflation are central to a central bank’s effectiveness.
Powell acknowledged the historical parallel directly at the March 18 press conference. “I don’t think we are going to let it colour our decision-making more than is appropriate,” he said of the 1970s lessons. But he also refused to minimise the risk. The pandemic, the tariff shock, and now the Iran war energy shock represent a “repeated set of things” — exactly the kind of cumulative pressure that historically has caused expectations to drift. The Fed, Powell emphasised, is “very strongly committed to doing what it takes to keep inflation expectations anchored at 2%.”
The Measurement Problem
One complicating factor in all of this is that “inflation expectations” are impossible to measure with precision. The Fed tracks multiple indicators simultaneously, and they do not always agree — creating space for interpretation and, at times, policy disagreement.
Market-based measures, such as the five-year/five-year forward breakeven rate — which derives expectations for average inflation over the five-year period starting five years from now — have remained relatively close to 2% even through the post-pandemic breakout of inflation. These instruments are widely watched precisely because they are based on actual investment decisions by market participants rather than survey responses. But as Al-Hussainy noted, articulating exactly what the Fed is targeting in expectations risks sacrificing “strategic ambiguity” — the flexibility to make discretionary policy judgments without being locked in by a specific public commitment.
Survey-based measures like the University of Michigan poll and the New York Fed’s monthly consumer survey tend to be more volatile and are often influenced heavily by gasoline prices — something the Fed has traditionally discounted. But that very volatility can itself become a problem when gasoline prices are persistently high: a survey that is volatile in part because of gas prices can nonetheless shift underlying attitudes about inflation over time if the elevated readings persist long enough. The New York Fed’s most recent poll — for February, before the conflict began — still showed anchored expectations. But that data predates a full month of high and rising oil prices, and policymakers are well aware its March reading will reflect a very different environment.
What Comes Next
The immediate path for the Fed is one of watchful paralysis. Markets have fully priced out rate cuts for 2026 and are pricing in a modest chance of a hike — a shift that itself does some of the Fed’s tightening work without the central bank needing to act. As Oliver Allen, senior U.S. economist at Pantheon Macroeconomics, put it: “The Fed is kind of in a holding pattern until we find a little more about the shape and scope and size of this energy shock that’s ahead of us.”
The April FOMC meeting is the next scheduled checkpoint. The June meeting — the next one with a full press conference — is already being watched as a potential inflection point if energy prices do not moderate and inflation readings continue to drift higher. Powell’s own dot plot at the March meeting still projected one rate cut in 2026, but he was explicit: “If we don’t see that progress on inflation, then you won’t see that rate cut.” And as the Iran war stretches into its fifth week with the Strait of Hormuz still subject to disruption and President Trump threatening further escalation if a deal is not reached, there is no clear endgame that would allow oil prices to retreat quickly.
For the Fed, the question is no longer whether the inflation expectations anchor is holding — for now, it appears to be, at least in the longer-term gauges. The question is whether it will continue to hold through a conflict of uncertain duration, in an economy that has not seen sustained 2% inflation in five years. That is precisely the question that the 1970s proved so costly to answer too late.
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