Central banks, the war in the Middle East, inflation, and the shifting rate landscape

Author: Tasneem Azim-Khan, Chief Investment Strategist, RBC PH&N Investment Counsel (With contributions from Noha Fazili, research analyst)
Data as of: June 19, 2026

Overview: The Iran war's inflationary shock has effectively eliminated near-term rate cut expectations in both the U.S. and Canada. The Fed under new Chairman Kevin Warsh is pivoting hawkish and dismantling forward guidance, while the Bank of Canada holds rates steady amid stagflationary crosscurrents.

Summary

Heading into 2026, consensus forecasts anticipated 50–80 basis points in rate cuts by the U.S. Federal Reserve, with the Bank of Canada potentially following suit. The U.S.-Israeli military strikes on Iran beginning February 28 overturned those expectations entirely. Energy prices surged by as much as 70% between late February and April before retreating, but remain approximately 30% above pre-conflict levels — a persistent inflationary impulse that has fundamentally reset the rate outlook for the remainder of the year.

The war's price impact is measurable and broadening. In the U.S., May's Consumer Price Index (CPI) rose 0.5% for the month and 4.2% year-over-year — the highest reading since May 2023 — driven primarily by energy costs including gas, diesel, and jet fuel. Core inflation (excluding food and energy) rose 2.9% annualized, well above the Fed's 2% target. Second-order inflationary effects are spreading into airfares, transportation costs, and services broadly. Even before the conflict, the Trump administration's haphazard tariff policy had introduced latent inflationary pressures; the war has amplified them materially.

The labour market provides no catalyst for cuts. May nonfarm payrolls rose by approximately 172,000 and unemployment held at 4.3% — a healthy reading that satisfies neither leg of the Fed's dual mandate as grounds for easing. Supply disruption from the Strait of Hormuz closure continues to weigh on oil inventories, which in the U.S. have fallen to the lowest level in over 40 years. Inventory rebuilds will take weeks to months, suggesting inflationary pressures could remain sticky into the near-to-medium term.

The Fed's June meeting marked a striking hawkish pivot. The Federal Open Market Committee (FOMC) held rates steady at 3.5%–3.75%, but newly appointed Chairman Kevin Warsh — who had publicly advocated for rate cuts in the lead-up to his nomination — struck a sharply different tone at his inaugural meeting. Warsh emphasized inflation risks forcefully, referencing inflation 19 times versus only four mentions of employment (RBC Economics). The median dot plot indicated a potential 25-basis-point hike later in 2026, a reversal of the rate-cut path priced in at year-start.

Equally consequential is Warsh's structural overhaul of Fed communications. His post-meeting statement ran just 130 words — versus the typical 300-plus words under previous leadership — and he did not submit a personal dot plot. Forward guidance, which Warsh has long criticized for constraining monetary policy agility, is being dismantled. Five task forces have been established covering communications, balance sheet policy, data collection, productivity and jobs, and inflation frameworks. While reducing the Fed's telegraphing has merit, the resulting communication void could amplify volatility in both equity and bond markets as investors are left to interpret policy direction from incoming data alone.

In Canada, the picture is one of cautious stasis. Annual inflation rose to just under 3% in April (from 2.4% in March), driven by energy. GDP contracted modestly for a second consecutive quarter — though not yet meeting the threshold for a formal recession. The Bank of Canada maintained its policy rate at 2.25% at its June meeting and expects geopolitically driven price pressures to ease toward year-end. RBC PH&N expects both central banks to remain on hold for the balance of 2026, with the Fed's bias tilting toward a hike — not a cut — should inflationary pressures persist.

For more insights on this and other important topics regarding today's economy and markets, please visit Tasneem’s insights page

Highlights 

● Consensus entering 2026 expected 50–80 bps in Fed rate cuts — expectations since reversed

● Energy prices surged ~70% from Feb. 28 to April before retreating; still ~30% above pre-conflict levels

● U.S. CPI rose 4.2% year-over-year in May 2026 — highest since May 2023

● Core inflation at 2.9% annualized — well above the Fed's 2% target

● Fed held rates steady at 3.5%–3.75% in June; median dot plot signals a potential 25-bps hike in 2026

● New Fed Chairman Kevin Warsh cited inflation 19 times vs. 4 mentions of employment at his first press conference (RBC Economics)

● Warsh's post-meeting statement: just 130 words vs. the typical 300+

● Five task forces established to overhaul Fed communications, balance sheet, inflation frameworks, and more

● U.S. Strategic Petroleum Reserve at its lowest level in over 40 years

● Bank of Canada holds policy rate at 2.25%; Canada inflation at just under 3% in April