By Sam Millette, Director of Fixed Income at Commonwealth Financial Network
For the Federal Reserve (Fed), the real inflation risk isn’t just higher prices—it’s higher expectations. Energy-driven inflation can fade on its own, but if it changes what consumers and businesses believe about future inflation, it can become harder to control. The latest jump in energy prices is exactly the kind of shock that can test those expectations.
Rising tensions in the Middle East have pushed energy prices higher, reintroducing inflation risk the Fed had hoped was fading. While the impact of ongoing hostilities has been widespread and headline-grabbing, rising energy prices have become a major focus of investor attention as the conflict drags on.
Oil and gas prices surged in March and have since remained high compared with recent history. If we don’t see a swift resolution to the conflict, prices could remain elevated for the foreseeable future. The critical question is whether this energy shock stays temporary or starts to shift inflation expectations.
This has created a problem for the Fed because rising energy costs are already putting upward pressure on inflation for consumers and businesses. This headwind complicates the central bank’s attempts to support its dual mandate of stable prices and a healthy job market. Looking forward, this pressure could materially affect monetary policy decisions throughout the year, but the outcome will depend largely on whether inflation expectations remain anchored.
To better understand how the Middle East conflict could influence inflation—and the Fed’s response—throughout the rest of 2026, let’s look at what has happened so far and what to watch next.
Déjà Vu from 2022: An Energy-Driven Inflation Spike
On a year-over-year basis, headline consumer prices rose 3.3 percent in March, up from 2.4 percent in February. Driven primarily by surging energy costs, this is the highest consumer inflation rate in almost two years.
Gas prices rose more than 21 percent on a seasonally adjusted basis in March, the largest monthly increase on record. We saw a similar rise in energy-driven inflation in early 2022, when Russia invaded Ukraine and energy costs spiked. Rising energy costs are a potential cause for concern for economists because they can spread inflationary pressure to other areas of the economy if prices remain elevated.
Looking forward, the key question for investors and the Fed will be whether the recent rise in energy costs is the start of a larger inflationary cycle or if this is a one-off event that will quickly filter through the data. Predicting where prices go from here, however, is easier said than done.
Inflation Expectations Matter More Than Just the Latest Data
Although most of the recent inflation updates have focused on backward-looking data—which does a good job of telling us what has already happened—they don’t help as much when trying to gauge where prices could go in the future. To do that, economists and investors typically turn to inflation expectations.
Here, the news is somewhat better for the Fed and the economy than headlines would suggest. So far, inflation expectations have remained relatively muted despite the rise in energy prices and headline inflation in March.
This is especially true for long-term inflation expectations, which have barely budged since the end of February. The recently released University of Michigan consumer confidence survey, for example, showed that 5- to 10-year consumer inflation expectations were 3.4 percent in April, up modestly from 3.3 percent in February. That’s a good sign for the Fed and the economy, and it suggests longer-term inflation expectations remain relatively well anchored.
Expectations are important to monitor because they can become a self-fulfilling prophecy when it comes to inflation. If consumers and businesses believe inflation will persist, they tend to change their spending habits, which in turn can create an environment of widespread, persistent inflation.
One way the Fed tries to promote price stability is by making sure that inflation expectations remain anchored around its stated inflation target. So far, the central bank has been able to do that; however, if we continue to see high energy prices affect other areas of the economy, this could change quickly.
What Investors—and the Fed—Should Watch Now
So, where does that leave investors as they try to figure out what’s going on with inflation and the Fed? There are a couple of takeaways to keep in mind in the coming weeks and months.
First, we’re likely to see continued short-term uncertainty, driven by shifting geopolitical risks. As long as the conflict in the Middle East continues, investors should be prepared to weather bouts of market turbulence.
But over the long run, it’s important to focus on the fundamentals because they ultimately drive the economy and markets. On the inflation front, this means not only tracking backward-looking price reports but also looking at expectations.
For now, expectations remain at levels that suggest investors and economists are willing to look past the energy shock. Whether that will remain the case will be top of mind for the Fed in the months ahead as it monitors the situation.
Put simply, as long as expectations remain muted, the Fed will likely continue with its wait-and-see approach when setting interest rates. That said, if we start to see long-term inflation expectations pick up from here, it could be a signal for the central bank that tighter monetary policy is needed by the end of the year.
Copyright © Commonwealth Financial Network,
Member FINRA/SIPC
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. These views are subject to change at any time. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict.
