Nothing spooks the Fed more than unmoored inflation expectations
As the Iran conflict reverberates through global markets, two of Wall Street's most closely watched economists are raising a quiet but consequential alarm: that war-driven inflation expectations, once unmoored from reality, have a way of becoming self-fulfilling — and that the Federal Reserve may soon find itself compelled to raise interest rates not because the economy is strong, but because the alternative is worse. The 10-year Treasury yield climbing to 4.6% is less a data point than a warning written in the language of capital, suggesting that markets are beginning to price in a world where the Fed's long-anticipated pivot toward easing gives way to a new era of tightening.
- The Iran conflict is injecting an inflationary psychology into markets that economists fear could become self-reinforcing — once people expect prices to keep rising, they often do.
- The 10-year Treasury yield has surged to 4.6% and the 2-year sits at 4.1%, signaling that bond investors are already repositioning for a world of higher-for-longer rates.
- Ed Yardeni expects the Fed to formally shift to a tightening bias in June and deliver a 25-basis-point rate hike in July, a reversal that would mark the end of the easing cycle.
- Traders, however, are not fully convinced — CME FedWatch puts the probability of a June hold at 98.8% and a July hike at just 19.5%, revealing a striking gap between economist forecasts and market bets.
- Even amid the uncertainty, equities have held firm — the S&P 500 is up nearly 8% year-to-date — and some analysts see a potential broadening of gains beyond tech as a sign of underlying resilience.
The Iran conflict is quietly rewriting the calculus on Wall Street, with two prominent economists warning that rising geopolitical tensions are pushing inflation expectations toward a dangerous threshold — one that could force the Federal Reserve to abandon rate cuts and begin hiking as soon as July.
Mark Zandi of Moody's Analytics is focused on what he calls "unmoored" inflation expectations. When businesses and consumers begin to believe that prices will rise regardless of Fed action, inflation becomes self-fulfilling. The bond market is already reflecting this anxiety: the 10-year Treasury yield has climbed to 4.6%, a signal that investors are pricing in both persistent inflation and the likelihood of rate increases ahead. Zandi's warning is unambiguous — the Fed will tighten until expectations cool, even at the cost of economic pain, because allowing inflation to take root would ultimately require even harsher measures.
Ed Yardeni offers a more precise timeline. He expects the Fed to drop its easing stance at the June meeting in favor of a tightening bias, followed by a 25-basis-point hike in July. The two-year Treasury yield at 4.1%, he argues, suggests markets already believe the current federal funds rate is too accommodative given the inflation backdrop.
Yet traders appear less certain. The CME's FedWatch tool assigns a 98.8% probability to a June hold and only a 19.5% chance of a July hike — a meaningful divergence from economist expectations that underscores genuine uncertainty about the Fed's next move.
Still, Yardeni sees room for cautious optimism. A pause in the equity rally, he suggests, could allow gains to broaden beyond the handful of mega-cap tech names that have dominated this year's returns — a healthier foundation for markets even in a tighter monetary environment. With the S&P 500 up nearly 8% year-to-date and the Nasdaq up over 12%, the resilience so far has been notable. Whether it holds depends on how the Iran situation unfolds and whether inflation expectations remain anchored to the Fed's 2% target — or begin, as Zandi fears, to drift.
The Iran conflict is reshaping how Wall Street thinks about inflation and interest rates. Two prominent economists—Mark Zandi of Moody's Analytics and Ed Yardeni—are warning that the geopolitical tensions are pushing inflation expectations higher in ways that could force the Federal Reserve's hand, potentially ending the era of rate cuts and ushering in aggressive increases starting as soon as July.
Zandi's concern centers on what he calls "unmoored" inflation expectations. When people and businesses begin to believe that prices will keep rising regardless of what the Fed does, inflation becomes self-fulfilling. The war is already visible in the bond markets: the 10-year Treasury yield has jumped to 4.6%, a signal that investors are pricing in both higher inflation and the likelihood of rate increases ahead. Zandi's warning is stark: the Fed will raise rates until those expectations cool, even if it means economic pain. The alternative—allowing inflation to take root—would require even steeper rate hikes down the road and a weaker overall economy to contain it.
Yardeni's forecast is more specific. He expects the Federal Reserve to abandon its easing stance at its June meeting, shifting instead to what he calls a "tightening bias." That shift would pave the way for a 25-basis-point rate hike in July. The bond market, he argues, is already pricing this in. The two-year Treasury yield sitting at 4.1% suggests that investors believe the current federal funds rate is simply too low given the inflation picture.
Yet the market reaction has been mixed. The CME Group's FedWatch tool shows traders assigning a 98.8% probability that the Fed will hold rates steady in June—a sign that the market is not yet fully convinced a tightening cycle is imminent. For July, the tool shows no probability of a rate cut, but only a 19.5% chance of a hike. This gap between what some economists expect and what traders are betting suggests genuine uncertainty about how aggressively the Fed will move.
Despite the inflation worries and the prospect of higher rates, Yardeni sees reasons for cautious optimism on equities. A market pause, he suggests, could actually be healthy—it would allow stocks beyond the technology sector to participate in gains, broadening the rally beyond the narrow group of mega-cap names that have driven much of this year's gains. He expects corporate earnings to continue growing even in a tighter monetary environment, without triggering a severe bear market decline.
The year so far has been solid for stocks. The S&P 500 is up 7.94% year-to-date, the Nasdaq Composite has gained 12.29%, and the Dow Jones has risen 2.69%. These gains have come despite—or perhaps because of—the shifting expectations about monetary policy. What happens next depends partly on how the Iran situation evolves and partly on whether inflation expectations actually do begin to unmoore themselves from the Fed's 2% target. If they do, the economists warn, the Fed will have little choice but to act, and the cost to growth could be substantial.
Citas Notables
The Fed will raise rates until inflation expectations cool, regardless of the hit to the broader economy, because inaction will cause inflation to metastasize, ultimately requiring even higher rates and a weaker economy to rein it back in.— Mark Zandi, Moody's Analytics
The bond market is calling for a tightening bias in June followed by a July rate hike, as the two-year Treasury yield signals the current federal funds rate is too low.— Ed Yardeni
La Conversación del Hearth Otra perspectiva de la historia
Why does the Fed care so much about inflation expectations? Can't they just manage actual inflation?
Because expectations shape behavior. If people believe prices will keep rising, they demand higher wages, businesses raise prices preemptively, and suddenly you have a self-reinforcing cycle. The Fed's credibility depends on keeping that cycle from starting in the first place.
So the Iran war is making people think inflation will be worse?
Yes. Oil and commodity prices are rising, supply chains could be disrupted, and that's pushing bond yields up. Investors are essentially saying: we think the Fed will need to raise rates to fight this.
But the CME tool shows traders don't expect a July rate hike. Isn't that a contradiction?
It is. The economists are reading the bond market one way—as a signal that rates need to go up. But traders betting on actual Fed decisions are more cautious. It's the difference between what the market thinks should happen and what it thinks will happen.
What does Yardeni mean by a "healthy broadening" of the market?
Right now, a handful of big tech stocks have driven most of the gains. A broadening would mean smaller companies and other sectors start participating. A pause in the rally could actually enable that, because it forces investors to look beyond the obvious winners.
If rates go up, won't that hurt corporate earnings?
It could, but Yardeni thinks earnings will keep growing anyway. The real risk is if the Fed has to raise rates so much that it tips the economy into recession. That's what Zandi is warning about—the Fed might have to choose between inflation and growth, and growth could lose.
So what are we watching for?
Whether inflation expectations actually start to unmoore. If they do, the Fed will move aggressively. If they stay anchored, maybe the market's more cautious view is right and July stays quiet.