The Fed will need to seriously consider raising rates at next week’s meeting, as upside risks to inflation could spiral out of control. While markets still expect detente to be the most likely path forward, the geopolitical backdrop has deteriorated significantly over the past week. If the current conflict continues for several more months, it could put a strain on global energy supplies and transport routes, causing prices to rise dramatically. Even putting those risks aside, inflation is still above the Fed’s 2% mandate, thanks to capital spending related to ramping up AI, strong consumer spending, and rising wages due to a tight labor market. Meanwhile, financial leverage and speculation are on the rise, creating the potential for asset bubbles. Due to the animal spirits of the AI fever, South Korea’s Kospi index rose more than 116% this year and then entered a bear market. The Bank of Korea waited too long to raise rates and regulators took too long to rein in excess margin, but this is an example of caution as the Fed risks making the same mistakes. Oil buffers are running dry Strategic reserve releases provide a critical buffer, with hundreds of millions of barrels being released around the world to offset supply disruptions. But those reserves are finite, and with U.S. inventories already near multi-decade lows, the ability to cushion further disruption is becoming increasingly limited. If the Strait of Hormuz remains effectively closed until the fall, the market could be forced to significantly raise oil prices as supplies tighten. The risks extend far beyond oil prices. The strait is a vital artery for global trade, transporting vast amounts of essential goods in addition to oil and LNG. Threats to the Red Sea and Black Sea routes are increasing pressure on global supply chains. With markets largely assuming price pressures will continue to ease, a prolonged conflict could reignite inflation through higher energy and transportation costs, weighing on consumers and businesses. Both Iran and the United States are likely to continue their conflict. This is because while both sides believe that continued escalation is in their strategic interests, the costs of withdrawal are increasing. Iran appears intent on using its control of the Strait of Hormuz and attacks on regional infrastructure and shipping as its most powerful means of countering U.S. pressure—especially before its ability to disrupt global markets with alternative energy routes and defense measures diminishes. Meanwhile, the United States faces pressure to prevent Iran from controlling key trade barriers and avoid the appearance of failing to protect energy security and nuclear proliferation. President Trump appears willing to accept a prolonged period of inflation if he allows the conflict to end. This stance is consistent with his own comments praising inflation, which he said he “loves”. Tariffs are back on the agenda in Canada and many other countries. The Fed risks being late.While the Fed may argue that monetary policy has a limited impact on tariffs and supply-side shocks, and that it has no way of knowing how large or long-lasting that impact will be, the bigger risk is if a spike in oil prices causes inflation expectations to become unanchored. Given the uncertainty of the outcome, the Fed will need to think more stochastically rather than in terms of a linear economic curve, in which case the potential upside in inflation given the spike in energy prices could justify faster action. If the situation in the Strait does not change by the Fed’s September meeting, the window for timely policy action has already closed, and the Fed may be on the back foot. Still, the weaker-than-expected consumer price index in June will likely keep the Fed on hold in July as it relies on backward-looking data distorted by a one-time flood of oil supplies during a brief cease-fire. Speeches by two influential Fed directors, Christopher Waller on July 13th and John Williams on July 15th, pointed to the favorable trajectory of oil prices and noted that it would help ease headline inflation. Waller said: “From now until the end of December, oil delivery market prices have regained much of their gains, which will put downward pressure on headline inflation in the coming months,” Williams said. “Given today’s oil prices and futures market pricing for next year, energy and related commodity prices will likely peak and approach levels seen before the Strait of Hormuz was first closed. Of course, this situation is fluid and subject to significant uncertainty.” A week and a half later, these observations appear outdated and likely do not reflect the governor’s current views. What’s interesting is that they’re not looking at the previous month’s oil price, but instead looking at the price for several months on the futures curve. This is because these prices more accurately reflect medium-term price expectations. December WTI futures are currently trading above $79 per barrel, just $6 below the high of the 2026 contract, suggesting market participants expect current transportation and production disruptions to continue. The market is already looking beyond the Consumer Price Index (CPI) statistics. The 10-year Treasury yield is now 6 basis points higher than it was on July 14, just before the announcement, as investors shift focus to the potential deterioration in supply chains and energy production. It is precisely at the long end of the yield curve that the Fed risks losing control by inaction. Expectations for a 25 basis point rate hike in July are also rising, with traders on Calsi pegging the probability at 22%, up from 4% on July 16, while CME’s FedWatch tool, which uses 30-day federal funds futures prices, suggests a 36% chance of a rate hike. Chairman Kevin Warsh has been tough on inflation, and the creation of a special committee to study how the Fed operates seems like a cautious approach, but it portends inaction. A 25 basis point rate hike in July would be a true signal that the Fed is serious about tackling inflation, without having to fully consider energy risks. Consumer Resilience Gives Fed Room to Tighten Consumer demand remains strong. According to CNBC/NRF Retail Monitor, core retail sales rose 10.1% in June compared to the same month last year, marking the ninth straight month of growth. Working class consumers care more about inflation than the stock market. Adam Parker of Trivariate Research argues that the K-shaped economy is “more of a balance sheet than an income statement.” Although low-income households are building less wealth than their higher-income counterparts, wage growth for low-income households is accelerating, credit conditions remain healthy, and “most households still say their finances are acceptable.” Consumers continue to spend. Christopher Harvey, CIBC’s head of equity and portfolio strategy, said in a Monday memo that executives’ comments on recent bank earnings have been very positive for consumers, and JPMorgan Chase CFO Jeremy Burnham said, In terms of performance, it’s just about the labor market. So you’re not going to hear anything new or differentiated from me about the labor market, which is just like everyone’s looking at the same numbers and it’s surprisingly resilient.” The other side of the Fed’s dual mandate, the unemployment rate, was 4.2% in June, below the 4.4% rate in December 2025, when the Fed last cut rates. Weekly jobless claims on Thursday were the lowest since 1969. It would be hard to argue that current labor conditions are preventing the Fed from raising rates. On the corporate side, advances in AI are driving up prices unabated. “The backlog continues to grow as supply remains constrained in many parts of the AI infrastructure stack,” UBS strategist Keith Parker said in a note on Monday. While Warsh was of the opinion that AI-driven productivity gains could lead to disinflation, Barclays analyst Jonathan Miller said, “Available data shows that industries with advanced AI adoption are already showing higher productivity growth.” “Given this, there is little reason to believe that such productivity gains are already leading to lower costs that reduce inflation, and we oppose moves to ease monetary policy on that basis.” “AI investment contributed one percentage point to real GDP growth last year, and the wealth effect led to an additional 90 basis points increase in consumption among high-income groups,” Parker said on Tuesday. Sticky Inflation It may also come down to the fact that five years above the 2% target rate is too long to be called transitory. Despite the softer-than-expected performance, core CPI in June was 2.6% year-on-year, the same as in December 2025. The June Core Personal Consumption Expenditure Price Index, the Fed’s preferred inflation measure, is scheduled to be released on Thursday after the Fed’s two-day meeting on Tuesday and Wednesday. Core PCE is expected to be 3.4% year over year. After hovering in the 2.6% to 3.0% range in 2024 and 2025, it is slowly rising in 2026. Bank of America analyst Aditya Barbu said core PCE is still 2.5% even after removing temporary factors, and that “the combination of continued rise in core inflation and a stable, if not improving, labor market argues for monetary tightening rather than an extended pause.” Bank of America global economist Claudio Yrigoyen said in a separate note that he expects the Fed to raise interest rates by a total of 75 basis points this year, adding: “If that happens,[Warsh]could lose the credibility he gained with his hawkish tone in June, in which case the yield curve will steepen and the long-term breakeven inflation will factor in a sustained inflation overshoot.” Don’t wait for the bubble to burst. Fed rate hikes could also help curb excessive speculation and promote financial stability. Credit debt rose more than 40% year-on-year, reaching levels last seen near the peak of the speculative market in 2000, 2007 and 2021, according to Leuthold Group data. And that doesn’t even take into account leveraged ETFs, which have seen astronomical asset growth this year. All this borrowed money is pushing the limits of the balance sheet capacity of the big money center banks and raising the cost of equity financing. South Korea is giving a warning of what can happen if you wait too long to take action. The boom in AI-related stocks such as Samsung and SK Hynix has spurred an increase in household debt that can be used to purchase stocks and real estate in Seoul. In mid-July, the Bank of Korea raised interest rates for the first time in more than three years and regulators halted the listing of new single-stock leveraged ETFs, after the Kospi index fell 26% from its high a month earlier, according to Goldman Sachs.More than 300,000 retail trading accounts (1 in 30 adults in the country) were wiped out in a single day after margin calls, and investors sought refunds, according to Goldman Sachs. The Fed’s challenge is not to accurately predict how these risks will play out, but to recognize that the cost of waiting may be far greater than the cost of acting preemptively. By raising rates by 25 basis points in July, the Fed will demonstrate continued resolve on inflation, give it room to act in the face of future shocks, and reduce the risk of being forced into another comeback. This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any securities or other financial assets. The Content is general in nature and does not reflect any individual’s unique personal circumstances. The above may not be appropriate for your particular situation. Before making any financial decisions, you should strongly consider seeking the advice of your own financial or investment advisor. Click here for full disclaimer.
