Notes on the Economy – Q1 2026 Summary

A Deer Caught in Headlights

On February 28, the United States and Israel struck Iran, kicking off the current military conflict. In response, Iran shut down the Strait of Hormuz, which before the conflict channeled 20% of global oil and liquefied natural gas (LNG) shipments. The closure increased oil prices from around $70 to over $100 per barrel. The severity of the impact will critically depend on the conflict’s duration. A resolution within the next few weeks will result in a short-term increase in inflation followed by global economies resuming their previous trajectories. A prolonged conflict is likely to significantly boost inflation and curtail global economic activity.

The United States’ economy entered the conflict in a good shape. Although GDP growth slowed down to an annualized rate of 0.7% in the fourth quarter of 2025, the number was distorted by a government shutdown. Restrictions on government spending lowered the headline GDP growth by 1.2 percentage points. Other expenditure items held up much better. Consumer spending increased by an annualized 2.0%. Business fixed investment grew at 2.2%, boosted by strong spending on data centers and other artificial intelligence (AI)-related equipment.

The International Monetary Fund (IMF) entered the year expecting global GDP growth to hold steady, at 3.3% in 2026, same as in 2025. The stable forecast reflected some slowdown in China, which struggles with sluggish domestic demand, and a reacceleration in Japan and Germany, where an expansionary fiscal policy was expected to help exit the stagnation observed over the past few years. A prolonged increase in energy prices will put these projections in jeopardy.

HEADLINES – WHAT’S IMPORTANT

1. Inflation Will Increase, but for How Long? – Inflation has been on a downward trend due to slowing increases in prices of shelter and services. An increase in energy prices will push inflation above 3.0% in the near term. Whether the increase proves temporary will depend on the duration of the conflict in the Middle East.
2. The Federal Reserve (Fed) Is Frozen Like a Deer Caught in Headlights – Higher inflation and slower growth leave policymakers with no good options. If the situation in the Middle East normalizes, the Fed might then deliver one or two more interest rate cuts from the current target range of 3.50-3.75%.
3. Global Equities Are off to a Rocky Start in 2026 – Stocks may endure a tumultuous spring as they face a triple threat of continued disruption of the flow of oil through the Strait of Hormuz, risks to the credit markets, and peaking AI capital expenditure growth rates. Investors may want to stay globally diversified, looking for potential opportunities in global value stocks.
4. Fixed Income Faces a Challenging Environment – Idiosyncratic credit problems within nonbank financial intermediaries have propagated throughout bond markets and the banking system. Treasury bonds can play a safe-haven role within an investment portfolio.

LOOKING AHEAD

Prospects for the economy hinge on the duration of the conflict in the Middle East. At a minimum, higher energy prices will lead to a temporary increase in inflation and dent consumers’ real disposable income. Increased uncertainty will be a restraint on growth of business capital expenditures. As a result, GDP growth is likely to remain below potential through most of 2026. The negative impact on inflation, growth, and markets will increase with the duration of the conflict.

Economic policy has limited space to mitigate the effects of geopolitical turmoil. Monetary policy will remain trapped between a rock and a hard place, as higher inflation and slower growth leave Fed policymakers without any good options. Rates are likely to remain on hold until the resolution of the Iran conflict, with some limited space for cuts afterward. Fiscal policy will remain supportive due to the One Big Beautiful Bill Act. Policy on tariffs remains uncertain after the Supreme Court ruling on February 20 declared that tariffs imposed under the International Emergency Economic Powers Act of 1977 were illegal. The administration subsequently imposed roughly equivalent tariffs using Section 122 of the Trade Act of 1974, but without Congressional approval, these can only legally remain in place for up to 150 days.

Global economic growth is also likely to be impacted by higher energy prices, as many economies in Europe and Asia rely on oil and natural gas imports to an extent larger than the United States. The 3.3% global GDP growth forecast by the IMF in January is likely to be revised lower.