Financial markets remained on edge this week as the conflict in the Middle East escalated, with uncertainty expanding into physical energy supply rather than just shipping disruptions. Reports of damage to key oil and LNG facilities in the Gulf, including infrastructure that could take months—if not longer—to repair, have injected a persistent risk premium into energy markets. Oil prices have swung sharply day‑to‑day and remain well above pre‑conflict levels (Chart 1). This dynamic remains consistent with the base case in our Quarterly Economic Forecast, but risks of even higher prices are growing. Higher gasoline prices hurt consumer spending and the prolonged uncertainty raises downside risks in energy‑importing regions. We flagged these concerns this week in our State Economic Forecast, especially for states with higher exposure to transportation, manufacturing, and energy‑intensive industries.

Against this backdrop, the Federal Reserve held its policy rate steady this week, as expected, but the statement was cautious. Chairman Powell acknowledged the heightened uncertainty stemming from the Middle East conflict, and revised projections showed higher inflation relative to December. The Fed continues to signal just one rate cut this year, reflecting concern that higher energy prices could slow the disinflation process at a time when core inflation is already proving sticky. Market reaction reinforced inflation concerns, with fed funds futures beginning to price a non‑trivial risk that the next move in rates may not be lower (Chart 2). Our commentary noted that the Fed appears intent on preserving flexibility, particularly given the risk that a prolonged energy shock could push the economy toward an uncomfortable mix of slower growth and firmer inflation.

Against this backdrop, markets continued to reprice risk this week in response to higher energy prices and a more cautious Federal Reserve. Equity markets struggled to find footing, while Treasury yields pushed higher as inflation risks moved back to the foreground. Incoming economic data offered a mixed picture. New home sales fell sharply in January, a reminder that interest‑rate‑sensitive sectors remain vulnerable to higher yields, though weather effects likely exaggerated the weakness. More broadly, the data flow reinforces that financial conditions are doing more of the near‑term adjustment work as the economy absorbs another external shock.

Looking ahead to next week, attention will undoubtedly remain on developments in the Middle East. Beyond the headlines, investors will also be watching how Fed officials are responding to the evolving situation and also the University of Michigan Consumer Sentiment Survey, a widely followed gauge of household confidence and inflation expectations. With energy prices and volatility high, these data could offer early signs of whether the current shock is beginning to weigh more materially on sentiment—or inflation expectations—an outcome that would further complicate the policy backdrop.