Iran and the Federal Reserve -- The "Three Scenarios" That Will Next Impact the Global Markets

Authored by: Dong Jing

Source: Wall Street Insights

The trajectory of the Iran situation and the outlook for Federal Reserve monetary policy are becoming the two most critical main themes shaping global markets.

In its latest report, Deutsche Bank’s economic research team systematically lays out three possible outcomes of Iran ceasefire negotiations and their potential impacts on the Fed’s policy path—ranging from the abating of near-term rate-hike risks, to multiple rate hikes in 2026, to policy direction facing two-way uncertainty. The three scenarios correspond to distinctly different market logics.

The bank’s analysis points out that the path of oil prices will directly affect how strongly inflation expectations are anchored, thereby determining whether the Fed needs to restart rate hikes. In the bank’s view, the most alarming situation is not the most extreme escalation scenario, but rather the middle state of “negotiation breakdown and stalemate”—in which persistently high oil prices are most likely to force the Fed to take concrete tightening actions in 2026.

At present, the latest developments in the geopolitical situation indicate that negotiations on extending the ceasefire agreement and reopening the Strait of Hormuz have made some progress, and the market has already reacted optimistically. Brent crude futures have fallen below $100 per barrel, touching a low close to that of nearly one month ago; the yield on 10-year U.S. Treasuries has also declined sharply, wiping out most of the gains from the previous week. However, uncertainty remains around negotiation details, and key disputes such as Iran’s nuclear program have not yet been resolved.

Scenario 1: Reaching a peace agreement—near-term rate-hike pressure eases, but medium-term risks remain

In the bank’s first scenario, negotiations break through and the Strait of Hormuz reopens. Oil prices continue their recent downward trend but remain above pre-war levels. U.S. Treasury yields fall further, and risk-asset markets strengthen overall as tail risks are removed, with financial conditions moving toward looser footing.

Against this backdrop, the pressure on the Fed to raise interest rates at its upcoming policy meetings will be noticeably reduced. As overall inflation data softens and short-term inflation expectations decline, Fed officials are inclined to treat recent core inflation pressures as temporary disturbances driven by energy price shocks, choosing to “look through” rather than respond immediately. Deutsche Bank expects that the new Fed chair, Warsh, will reinforce this inclination.

However, the bank also warns that the baseline narrative that “inflation is not persistent” needs time to be disproven, and the risk of rate hikes has not disappeared. If the labor market remains tight, inflation expectations move higher further, or inflation stays elevated even after tariff and energy pressures fade, the risk of raising policy rates is more likely to materialize in 2027.

Scenario 2: Negotiation breakdown and stalemate—highest rate-hike risk in 2026

Deutsche Bank characterizes the second scenario as the one with the “highest rate-hike risk” among the three current scenarios. In this scenario, the peace agreement negotiations fail, the Strait of Hormuz stays closed for the long term, but the conflict does not further escalate; oil prices remain high rather than surging sharply.

Sustained high oil prices would transmit more clearly to core inflation, while also increasing the risk that inflation expectations become unanchored. At the same time, in this scenario, oil prices are not high enough to seriously damage demand and force the Fed to shift its attention to the employment market. This means the Fed would face inflationary pressure unilaterally, without a “justification to stand pat” by citing an economic downturn.

The bank believes the Fed is unlikely to take rate-hike action before the September policy meeting. A policy shift requires multiple steps, including removing the inclination toward easing (June), some officials publicly discussing the possibility of rate hikes (from July to September), and the committee forming consensus.

But it also points out that recently Fed Governor Waller said that if “inflation does not fall back quickly,” rate hikes might be a reasonable choice, suggesting the Fed may be willing to tighten policy more rapidly. Therefore, the possibility of multiple rate hikes in 2026 should not be ruled out.

Scenario 3: Conflict escalates again—policy outlook faces two-way risks

The third scenario assumes that the Iran situation escalates again, with oil prices experiencing a larger-scale and more sustained surge. Deutsche Bank believes this does not necessarily mean the Fed will move toward rate hikes unilaterally; instead, it would introduce two-way uncertainty into the policy outlook.

On one hand, escalation would push overall inflation up by a greater magnitude and for a longer duration, with core inflation facing more significant transmission risk and the likelihood of inflation expectations becoming unanchored rising materially. The Fed would then need to show, through explicit policy communication, that it is willing to tighten policy to address price stability risks.

On the other hand, a large and sustained rise in oil prices would increase the risk of nonlinear shocks hitting the real economy, and ultimately spill over to the labor market.

Deutsche Bank notes that consumers can currently withstand energy prices near the current level, and tax-cut policies offset, to some extent, the pressure from the increase in oil prices. But if oil and gas prices rise further substantially, this buffer would be used up. At that point, the labor market could slip out of its current fragile equilibrium of “low hiring, low layoffs,” leading to further demand contraction or ultimately a wave of layoffs.

In this scenario, the Fed’s final policy stance would depend on the sequence in which the two kinds of risks above materialize: if the economy remains resilient and inflation expectations become unanchored first, strong tightening would be needed to respond; if cracks appear first in the labor market, the Fed might pivot toward easing, using the argument that forward-looking price pressures are weakening.

Bringing the three scenarios together, Deutsche Bank’s analytical framework reveals a clear chain of logic: the Iran situation determines the direction of oil prices; the path of oil prices determines the nature and duration of inflation pressure; and whether inflation expectations become unanchored ultimately determines the Fed’s policy room.

The most important signals to watch right now include: substantive progress in ceasefire negotiations, whether Brent crude can stabilize below $100 per barrel, and changes in the wording used by Fed officials in the coming series of meetings—especially whether they begin removing the inclination toward easing, or whether any officials publicly discuss the possibility of rate hikes. These signals will be key observation windows for assessing the probability distribution across the three scenarios described above.