Monthly Economic & Interest Rate Outlook (MEIRO) – Inflation cools again, but rising oil prices could challenge Fed patience

Key updates: We still think that the Federal Reserve (Fed) stays on hold for 2026 and lowered our outlook for the unemployment rate and inflation both by -0.1. But no deal with Iran means inflation will be dogging the Fed until there is a lasting deal.

Economic environment:

• The U.S. economic activity remains mixed, reverting to the ‘one foot on the gas, one foot on the brake’ feeling as recent improvement in manufacturing surveys is offset by the softer job market. 
• But inflation is seemingly tied to an Iran deal. While inflation moderated again in July, the 10% jump in crude oil prices this past week underscores the risk that inflation progress could stall or reverse.

Federal Reserve (Fed) outlook:

• We believe the Fed will stay on hold, taking a wait-and-see approach towards oil-induced inflation and solid, albeit cooler, labor market. With both consumer and wholesale inflation cooling again in July, the case for Fed rate hikes appears less urgent. We still believe the bar for a rate hike remains high.
• Yet, inflation uncertainty is a major problem for the Fed, especially on the credibility front. There’s still no Iran deal, which is propelling crude oil prices higher and could pose a challenge for the Fed to do “something” about inflation.

Impact on yields:

• Traders are currently positioning for the Fed to execute one 0.25% rate hike before year-end. The 2-year U.S. Treasury yield is roughly 75 basis points (0.75%) above pre-conflict levels. We expect short-dated rates to decline if a durable resolution emerges in the Middle East and the Fed avoids raising rates.
• The unresolved U.S.-Iran peace talks are keeping longer-term (>3 years) yields elevated and choppy. A peace agreement in the Middle East should encourage lower yields, but fiscal and trade policy concerns will keep them relatively sticky, leading to a resumption of U.S. yield curve steepening.

• The U.S. economy continues to plod through the uncertainty caused by the Iran War and the subsequent spike in gasoline prices. Important drivers – such as AI-led tech investment – have taken the baton as a key growth engine. Yet, it feels uneven given volatile gasoline prices and a lack of sustained hiring.
• The Iran conflict continues to cast a long shadow over the economic outlook, with crude oil prices and inflation especially vulnerable. Extended disruptions in the Strait of Hormuz would heighten those risks.
• Uncertainty remains another downside risk – for trade and supply chains, for Fed policy, etc. That widens the range of potential economic outcomes.
  • Government funding, which lapses at fiscal year-end on September 30th, is once again a pressing issue. But Congress appears more focused on the midterm elections and a stopgap bill rather than a long-term deal.
• Three positive drivers remain intact – tax incentives for consumers and businesses, tariffs are lower than in ’25 (along with tariff refunds), and continued investment in AI and technology spending. On the first point, personal federal tax refunds ended up 18.3% above last year. Those are a very real boost to consumers, along with a substantially reduced bill for high-income taxpayers. On the second point, the effective U.S. tariff rate has dropped to 11.1% from roughly 15% at the end of 2025.
• Employment trends remain critical, but the ‘low hire/low fire’ trend remains intact. Job growth stumbled in July, pulling down the six-month average to 44,000 per month. While the unemployment rate dipped to 4.1%, the decline was more about a shrinking labor pool than labor market strength.
• Reshoring will continue to support growth, but don’t expect big job growth within manufacturing. Most of the new plants being built in the U.S. are heavily automated and mechanized. Indeed, there will initially be construction-related work, along with ongoing logistics jobs, but reshoring won’t meaningfully boost hiring within manufacturing. 

• We maintain our view that the Fed remains on hold for now, taking a wait-and-see stance towards oil-induced inflation and recent labor market resilience. Inflation expectations remain anchored and recent cooling in a handful of inflation data points reduce the likelihood that the Fed will need to tighten policy soon.
• Base case scenario: We believe that peak tensions between the U.S. and Iran are behind us. Against that backdrop, U.S. Treasury yields should fall (i.e., prices rise) from current levels across the curve with the assumptions that persistent inflation worries ease and the Fed avoids increasing its policy rate. If shipping traffic through the Strait of Hormuz improves in the coming weeks, markets should grow more confident that inflationary pressures will further subside. That would likely help the yield on the 10-year fall towards 4.25%.
  • In this scenario, yield declines are likely to be more pronounced in shorter-dated maturities, which are currently positioned for a higher Fed funds rate. Over the past month, the 2-year Treasury yield fell meaningfully as the Fed refrained from raising rates at its July meeting. If policymakers ultimately avoid raising rates, short-dated yields should move lower. Longer-dated yields should be spurred somewhat lower, too. However, U.S. fiscal imbalances, resilient economic growth, and robust government debt issuance may constrain their decline. Thus, the net result should be a return to steepening in the yield curve as longer-dated yields prove a bit “stickier.”
• A less favorable scenario would be if the conflict stays unresolved for an extended period and the Strait of Hormuz remains shuttered. If a prolonged “no-deal” environment emerges, inflation expectations could move higher alongside increased U.S. military spending, worsened budget deficits, and the potential for more government debt issuance. This combination of elevated risks could keep interest rates elevated across the yield curve and potentially force the Fed’s hand towards raising interest rates. This would likely push yields higher beyond 3-year maturities, particularly at the long end of the yield curve.
  • However, we suspect the 10-year U.S. Treasury yield would find it difficult to sustainably breach the 4.5% threshold (as evidenced at the beginning of July) for two primary reasons. First, a prolonged conflict would fuel greater global growth concerns, which tend to apply downward yield pressure. Second, the equity market has shown discomfort in recent years when the 10-year yield has flirted with 4.5%, powering a flight-to-quality into U.S. Treasuries.
  • In shorter-dated maturities, we would expect yields to move only slightly higher from current levels, having already moved higher on recent inflationary concerns. Traders have positioned the Fed to hike rates one time (0.25%), but we believe that the bar for additional Fed rate hikes remains high.
• Borrowing costs: On balance, lending rates continue to remain elevated along with the sustained rise in interest rates. While we expect borrowing costs to fall modestly over the next year-and-a-half, we don’t anticipate a dramatic decline in rates nor a big catalyst for growth. For instance, 30-year fixed mortgage rates should drift modestly lower, but home prices are a much larger challenge for housing affordability than mortgage rates.
• U.S. credit spreads remain tight amid the ongoing geopolitical tensions, driven by the strength of the corporate sector throughout the year. Current spreads still signal the market’s confidence in the U.S. economy and its companies. In March, as credit spreads approached their widest levels in almost a year, we upgraded our outlook for the high yield corporate bond sector from less attractive to neutral. Although they have tightened meaningfully, absolute yields are supportive of constructive total return outlooks for investment grade and high yield corporate bonds.

• A prolonged Iranian blockade of the Strait of Hormuz remains a risk to the global economy. Nearly six months into the unresolved conflict with Iran, the threat of an extended energy shortage continues to grow. Crude oil risk premiums remain elevated, though well below the levels seen at the conflict’s onset.
• Coordinated foreign exchange intervention to support the Japanese yen failed to reassure markets. Japan’s government is expected to back faster rate hikes to help stem the yen’s decline.
• Ukraine’s 40-day effort to pressure Russia into ending the war failed to change Moscow’s position. Ukrainian missile strikes targeted oil refineries and other critical infrastructure. In response, Russia began attacking the key seaport city of Odessa, weakening Ukraine’s ability to trade through the Black Sea route.
• Robust U.S. growth relative to its peers and higher yields have boosted the U.S. dollar. We expect a wider, volatile range for the U.S. dollar with a near-term upside bias.
• The key elections in 2026 are the U.S. midterms and Brazil’s presidential election. Market-friendly presidential elections in Colombia and Peru resulted in the election of Abelardo Espriella and Keiko Fujimori, respectively, which should result in greater cooperation within the Americas. 

• Expansion or escalation in the Iran conflict, particularly regarding the Strait of Hormuz, could result in sustainably higher inflation by disrupting the global oil supply chain. That would hinder declines in U.S. interest rates and hamper global growth.
• Continued trade uncertainty or new flare-ups, which would ratchet up uncertainty.
• While companies remain in “low hire/low fire” mode during 2025, a dramatic deterioration in the labor market would slow economic momentum.
• Global bond market participants initiate a “buyer’s strike” against government-issued debt in response to ongoing fiscal largesse, robust debt issuance, and mounting interest costs, thereby forcing U.S. and international yields (i.e., government borrowing costs) higher.
• Additional government dysfunction and the potential for policy gridlock to impede important legislation, such as federal budgets, the debt ceiling, and key confirmations. Democratic gains in the midterm elections could upend the current Republican mandate.
• Slower/sluggish global growth, primarily in China, Europe, and the United Kingdom.
• Political tensions abroad causing reduced demand for U.S. goods or travel to the U.S., with some countries actively avoiding American products.