Goldman Sachs: Higher oil prices are pushing up hike pricing, but the Fed's actual hike probability is lower than the market expects

Overview

This report discusses the impact of the oil price increase since the Iran war on U.S. inflation, growth, and the Fed's policy path. Market pricing for the 2026 federal funds rate has moved up sharply and implies about a 45% probability of an FOMC hike; Goldman Sachs believes this hike risk is overstated. The core view is that the current supply shock is smaller than the oil shocks that historically led to persistent inflation problems, and that the starting state of the U.S. economy is less likely to produce a wage-price spiral or broad inflation spillover.

Core views

Goldman Sachs believes the Fed is unlikely to hike solely because oil prices rise. First, the current oil shock is smaller and less persistent than in the 1970s, and it is not accompanied by the broad supply chain shortages seen in 2021-2022. Second, a softer labor market, slower wage growth, and anchored inflation expectations reduce second-round inflation effects. Third, the current policy rate is already above estimates of neutral, and financial conditions have tightened as well. Fourth, historically, Fed officials and FOMC forecasts do not usually raise the policy rate path systematically simply because of an oil shock.

Analysis framework

The report compares the current oil shock with the inflation episodes of the 1970s and 2021-2022, and uses labor market tightness, wage pressure, inflation expectations, inflation breadth, leading inflation pressure indicators, and the stance of monetary and fiscal policy to build an inflation risk dashboard. Goldman Sachs also uses G10 data to estimate the probability that a negative supply shock will cause core inflation to accelerate by more than 0.5 percentage points after 1.5 years.

Methodology notes

• Macro policy reaction functionFed reaction function analysis to oil shocks

  Compares the historical relationship among oil shocks, FOMC rate forecasts, and Fed officials' speeches.

  The report finds that the Fed typically does not tighten policy simply because oil prices rise; by contrast, ECB officials' speeches are more strongly associated with hawkish policy language after oil shocks.

• Inflation risk monitoringPersistent inflation risk dashboard

  Aggregates labor market, wages, inflation expectations, inflation breadth, leading price pressures, monetary policy, and fiscal policy indicators.

  The dashboard shows that current persistent inflation risk is lower than in the 1970s and 2021-2022, and is closer to the environment of the 1990s through the 2000s.

• Quantitative modelCore inflation acceleration probability model after a negative supply shock

  Uses oil shocks and VAT increases as proxies for negative supply shocks to estimate the probability that core inflation will materially accelerate thereafter.

  The model suggests that when the labor market is looser, long-term inflation expectations are anchored, and fiscal policy is less expansionary, the probability that a negative supply shock turns into persistent core inflation is lower.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• U.S. rates

  The report's core asset mapping, directly discussing the federal funds rate, the FOMC policy path, and market pricing.

  Strengths

  If Goldman Sachs is right, current market pricing for hike risk may be too high, leaving room for the rate path to be repriced in a more dovish direction.

  Weaknesses

  If the oil shock broadens and inflation breadth rises, the rates market may continue to price a higher policy rate.

  Comparison

  Goldman Sachs' probability-weighted forecast is more dovish than both its base forecast and market pricing.

  Risks

  De-anchored inflation expectations, a renewed rise in wage pressure, a broader supply chain shock, or renewed fiscal stimulus.

• Crude oil

  The oil shock is the report's main macro scenario variable.

  Strengths

  Higher oil prices are a direct driver of headline inflation and of rising demand for hedge protection against hikes in the market.

  Weaknesses

  The report argues that the current shock is still smaller in scale and breadth than in the 1970s and 2021-2022, and that oil is unlikely to keep rising by the same magnitude every year.

  Comparison

  The current shock is weaker than in the 1970s and not as broad as the 2021-2022 supply chain disruption.

  Risks

  A prolonged Iran war could disrupt Middle East trade flows and widen pressure on non-oil goods prices and supply chains.

• U.S. Treasuries

  Affected by the Fed's policy path, recession probability, and inflation risk together.

  Strengths

  If hike probability falls or recession risk rises, Treasuries could benefit from more dovish rate expectations.

  Weaknesses

  Near-term increases in headline inflation may limit the downside in long-end yields.

  Comparison

  The report indicates that the forecast for the 10-year U.S. Treasury yield is broadly maintained around 4.18%-4.25%.

  Risks

  Rising persistent inflation risk, a renewed upward shift in the policy rate path, or wider term premium.

• U.S. dollar

  Indirectly influenced by Fed policy divergence versus other central banks.

  Strengths

  If the market continues to worry about U.S. inflation and tail risk of hikes, the dollar may gain support from policy differentials.

  Weaknesses

  If Goldman Sachs' dovish view materializes and U.S. recession risk rises, support for the dollar could weaken.

  Comparison

  The report notes that ECB-related hike pricing changed more sharply, showing divergence in cross-central-bank policy expectations.

  Risks

  The asymmetric impact of the oil shock on global inflation and central bank responses could change FX direction.

Key data

• Market-implied probability of a 2026 FOMC hikeAbout 45%About 12% before the Iran war; market pricing was revised up sharply after the war.
• Market-implied probability of 1-2 rate cutsAbout 18%The base-case probability before the war was about 35%-40%.
• ECB market-implied hike magnitude for 2026About 70bpBefore the war, the market priced in about 8bp of cuts.
• Federal funds rate relative to the neutral rateAbout 50-75bp aboveThe report believes this reduces the need for further hikes.
• Change in financial conditionsTightened by nearly 80bpFinancial conditions have tightened significantly since the conflict began.
• Goldman Sachs subjective recession probability over the next 12 months30%Raised by 10 percentage points after the Iran war began.
• Goldman Sachs 2026 unemployment rate forecast4.6%Higher oil prices are expected to weigh on real disposable income, growth, and employment.
• Goldman Sachs terminal rate base-case forecast3%-3.25%The report says the risks over the next year tilt lower relative to this terminal rate forecast.

Impact & implications

The main implication for rates markets is that the market may be overpricing protection against a 2026 Fed hike, and Goldman Sachs' probability-weighted rate path is more dovish than the market's. For macro assets, higher oil prices lift headline inflation in the short term and weigh on growth, but unless broad inflation spillover or de-anchoring inflation expectations emerge, the Fed is more likely to hold or cut rates rather than hike again. If the economy enters recession, even with an oil shock, the FOMC would very likely cut rates.

Risks

• The Iran war continues or escalates, disrupting Middle East trade flows and amplifying supply chain shocks.
• Oil prices rise further sharply, making the inflation shock stronger and spilling into core inflation.
• The labor market tightens again and wage growth re-accelerates.
• Medium- to long-term inflation expectations become de-anchored.
• Fiscal policy turns expansionary again, amplifying demand pressure after the supply shock.
• Market demand for insurance against tail-risk hikes continues to rise.

What to watch

• The magnitude and duration of the oil price increase, and whether it spreads to non-oil goods.
• Supplier delivery times, inventory-to-sales ratios, and signs of disrupted Middle East trade.
• Unemployment, job openings, wage growth, and labor market tightness.
• Medium- to long-term inflation expectations from consumers, businesses, markets, and professional forecasters.
• Early inflation pressure signals in core PCE components with low oil content.
• Whether inflation breadth spreads from energy-related components into broader core components.
• Whether FOMC officials' speeches, the SEP rate dot plot, and the Chair's comments turn more hawkish.
• Whether financial conditions continue to tighten or begin to loosen again.