Fighting Oil or the Deficit? Decoding the Fed’s First Hike of the Cycle

Driss EFFINA, PhD Independent Researcher, Global Strategy Files Decoded, analysis note No. 7, 24 October 2026. Reading time: about 60 minutes

Abstract

On 16 September 2026 the Federal Open Market Committee raised the federal funds target range by a quarter point, to 3.75 to 4.00 percent, its first increase since July 2023 and the first of the cycle under Chair Kevin Warsh. The move came as Brent crude climbed back above 110 dollars a barrel, headline inflation returned to 3.7 percent and the 10-year Treasury yield crossed 5 percent with the federal deficit at about 2.0 trillion dollars. Was the Fed fighting an oil shock it cannot control, or leaning against the inflationary consequences of fiscal policy? This note tests both readings. It decomposes the stance into energy, core and demand, and fiscal components; compares the 2026 decisions and projections with nine policy rules and an estimated reaction function; splits the rise in the 10-year yield into expected policy and term premium; builds an original fiscal dominance pressure indicator; and measures spillovers to Canada, the United Kingdom and the euro area. The answer is that the Fed is fighting neither oil nor the deficit directly. It is fighting core inflation and the demand that fiscal policy helps to sustain, and it has absorbed the deficit into a higher neutral rate rather than into the hike. Markets go further: they price a neutral rate 1 to 1.5 points above the FOMC’s 3.2 percent. Scenarios for the next four meetings, a dashboard of twelve indicators and a calendar to mid-2027 complete the analysis.

Keywords: Federal Reserve, FOMC, Kevin Warsh, rate hike, oil shock, Taylor rule, neutral rate, term premium, fiscal dominance, Treasury yields, spillovers, Bank of Canada, Bank of England, ECB

JEL codes: E43, E52, E58, E62, F42, Q43

Key findings

1. Not oil. Rules that respond to headline inflation miss the six 2026 decisions by 1.07 to 1.41 points (root mean squared error). Between March and September the FOMC raised its 2026 headline PCE projection by 1.0 point, yet the end-2026 median dot rose by only 0.7 point, all of it explained by next year’s core inflation (+0.45), lower unemployment (+0.20) and a higher neutral rate (+0.10). A headline rule would have added 1.5 points; energy received zero weight. 2. A forward-looking core rule fits the Committee almost exactly. A Taylor rule fed with the FOMC’s own next-year core PCE and unemployment projections reproduces the March, June and September median dots with an error of 0.07 point. On realised data, an inertial core rule (RMSE 0.13) tracks the decisions and prescribes 4.00 percent for October: half a step, pointing to December rather than October. 3. The deficit sits in the level, not in the move. The FOMC’s longer-run rate has risen from 2.5 to 3.2 percent since 2023, 81 percent of the 0.86 point that Laubach’s estimate of deficit effects implies for the projected rise in deficits (from 4.8 to 8.2 percent of GDP). This fiscal and structural component accounts for half of the 1.375 points by which the 3.875 percent midpoint exceeds the pre-2024 neutral rate; on core inflation the real policy rate (0.87 percent) is still below the Committee’s own neutral. 4. Markets price more deficit than the Fed. Of the 1.26-point rise in the 10-year yield between the end of February and the end of September, 75 percent was expected short rates and 25 percent term premium (ACM, 0.52 to 0.82 percent). The market’s expected average short rate over ten years exceeds the FOMC’s projected path by 0.65 to 1.04 points, implying a market neutral rate of 4.2 to 4.7 percent against the Committee’s 3.2 percent. 5. Fiscal dominance pressure is building, not binding. The author’s six-component indicator stands 4.0 standard deviations above its 2015 to 2019 baseline in 2026 and rises to 7.3 by 2031 on IMF projections; net interest took 21.2 percent of federal receipts in fiscal 2026. Yet the Fed cut its bill purchases from 40 to 10 billion dollars a month, and net of mortgage-backed securities run-off its holdings rose by only 9.3 percent of the deficit. 6. The long end exports the tightening. In 2026 a 1-point move in the US 10-year yield has passed through 0.78 point to Canadian 5-year yields and 0.71 and 1.06 to German and French 10-year yields; Canadian 5-year yields are up 0.75 point since February with the Bank of Canada on hold. In the author’s scenarios the probability-weighted midpoint reaches 4.04 percent after December and 4.06 percent in March 2027, with a 65 percent probability of a December hike, below the 76 to 80 percent priced by markets.

1. Introduction

A central bank that raises interest rates in the middle of an oil shock invites two suspicions. The first is that it is trying to push down a price it does not set: monetary policy cannot pump oil through the Strait of Hormuz, and a hike aimed at energy prices only adds a demand squeeze to a supply squeeze. The second is subtler. With the federal deficit at about 2.0 trillion dollars, net interest above 1.1 trillion dollars and 10-year yields at their highest since 2007, a hike could be read as the Fed taking on the inflationary consequences of a fiscal policy that Congress and the Treasury will not address. In that reading, the Fed is fighting the deficit.

Both suspicions matter for what comes next. If the Fed is fighting oil, the hike will reverse when Brent falls. If it is fighting the deficit, rates will stay high regardless of oil, and the 2027 debate will be about who controls the long end of the curve. If it is doing neither, the path depends on wages, services prices and the labour market, and oil is a risk factor rather than a target.

This note answers the question with evidence rather than by inference from statements. Chair Warsh has said that he is “not in the forward guidance business”, and the September statement offered no explanation beyond a “timelier return” to 2 percent, so the reaction function must be reconstructed from what the Committee did and projected. Figure 1 sets out the three channels and the tests applied to each. Section 2 reviews the 2026 decisions, Section 3 decomposes the stance, Section 4 compares the decisions with policy rules, Section 5 turns to the term premium and Section 6 to fiscal dominance pressure. Section 7 gives the verdict, Section 8 measures spillovers to Canada, the United Kingdom and the euro area, and Sections 9 to 12 present scenarios, a dashboard, implications and a calendar.

The note complements Decoded No. 1, on who pays for the 2026 yield surge, and Decoded No. 3, on second-round wage effects. Its object is the central bank’s reaction function itself: which force moved the policy rate, and which moved the yield curve without the Fed’s help.

2. The 2026 record: six meetings, a new chair and a hike

2.1 From an easing bias to a hike

The Federal Reserve entered 2026 with its target range at 3.50 to 3.75 percent after three quarter-point cuts between September and December 2025. The January statement described activity as expanding “at a solid pace” and inflation as “somewhat elevated”, and two members, Stephen Miran and Christopher Waller, dissented in favour of a further cut. In March, less than three weeks after the war involving Iran began and oil supply through the Strait of Hormuz was disrupted, the Committee held again and noted that the implications of developments in the Middle East for the US economy were “uncertain”. It kept the language on “the extent and timing of additional adjustments”, which markets read as a residual easing bias.

The April meeting, Jerome Powell’s last as chair, marked the turn. Inflation was now “elevated” rather than “somewhat elevated”, with energy prices cited explicitly, and the vote was 8 to 4, the largest number of dissents since 1992: Governor Miran wanted a cut, while Beth Hammack, Neel Kashkari and Lorie Logan accepted the hold but objected to the easing bias. Kevin Warsh was confirmed by the Senate in mid-May and chaired his first meeting on 16 and 17 June. The June statement dropped forward guidance, attributed part of the overshoot to “supply shocks that have driven price increases in certain sectors, including energy”, and added a sentence that has stayed since: “The Committee will deliver price stability.” The vote was unanimous. In July the same three regional presidents dissented for an immediate quarter-point increase. In September the Committee moved, by 12 votes to none.

Table 1. The six FOMC decisions of 2026. Midpoint of the target range after each meeting. Sources: Federal Reserve Board, FOMC statements; Continuum Economics and CF Benchmarks meeting reviews for the composition of dissents.

Two features of this record matter. The hawkish pressure came from the Reserve Bank presidents before the Board: ten dissenting votes were cast in the first five meetings, and the three regional presidents moved from objecting to the easing bias in April to voting for a hike in July. And the statements never mentioned fiscal policy, the deficit or long-term yields. Whatever weight the Committee gives to the deficit, it has not put it in writing.

The implementation note of 16 September set interest on reserve balances at 3.90 percent, the overnight reverse repurchase rate at 3.75 percent and the standing repo and primary credit rates at 4.00 percent, effective 17 September. The balance sheet language was unchanged: the Committee continues to maintain ample reserves and to buy Treasury bills “as appropriate”.

2.2 What the Committee projected

The Summary of Economic Projections is the closest thing the FOMC now offers to a statement of intent. Warsh has declined to submit his own projections, citing his long-held reservations about the exercise “at least as currently structured”, but the other eighteen participants continue to submit. Table 2 shows how the projections moved through the year.

Table 2. FOMC median projections, March, June and September 2026. Real GDP and inflation: fourth quarter to fourth quarter; unemployment: fourth-quarter average; federal funds rate: year-end midpoint. Source: Federal Reserve Board, Summary of Economic Projections.

The September dot plot is unusually concentrated: twelve of eighteen participants placed the end-2026 rate at 4.125 percent, four at 4.375 percent and two at 3.875 percent. In June, eight had still pencilled in 3.625 percent, the pre-hike midpoint. The median participant expects core PCE inflation to return to 2.0 percent only in 2029, a point Warsh acknowledged at his press conference by describing these as “the forecasts of my 18 colleagues”.

Figure 2 places the decisions in context. Brent rose from 70.9 dollars a barrel in February to 117.3 dollars in April, fell to 83.8 dollars in July and climbed to 114.2 dollars in September and 127.0 dollars in early October. Headline CPI inflation went from 2.4 percent in February to 4.2 percent in May and 3.7 percent in September. Core inflation barely moved: core CPI was 2.5 percent in February and 2.6 percent in September, and core PCE inflation rose from 2.96 to 3.01 percent between February and August. Michigan one-year household expectations jumped from 3.4 to 4.8 percent between February and May before easing to 4.0 percent in August; the 5-year breakeven peaked at 2.62 percent in May and stood at 2.36 percent in October. Unemployment fell from 4.4 percent in February to 4.1 percent in August and was 4.2 percent in September.

A first look at the results

The full note goes much further, with original models, scenarios and a dashboard of leading indicators. Two of its 14 charts and diagrams are shown below.

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Frequently asked questions

Sources

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