Forget Rate Cuts: What if the Fed Needs to Hike Rates in 2026?

The Iran conflict has thrown both the U.S. economic outlook and Fed policy plans out the window. While geopolitical events tend to be short term in nature and conditions often return to the way they were after tensions settle, this conflict is looking more and more like it will be a problem for a while.

It's also impacting what the Fed might be able to do this year. For months, the Fed Funds futures market has been pricing in rate cuts this year. Even with inflation remaining stubbornly above target and several Fed members expressing hesitation to cut rates in light of this, futures had been indicating expectations for two rate cuts in 2026.

This belief was largely based on the notion that gross domestic product (GDP) growth was likely to slow and the labor market showed stagnant job growth. Plus, if the current oil spike was due to a supply driven event, it may only be temporarily inflationary. Long-term macro fundamentals should outweigh short-term shocks.

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But the inflation question still isn't going away. It doesn't seem out of the question that the Iran conflict could drag out for months. If Iran is willing to close off the Strait of Hormuz indefinitely despite the United States government's insistence that it won't withdraw until Iran surrenders, we could be facing a long stalemate.

This all leads to one big question: Should the Fed be giving stronger consideration to hiking rates here, rather than cutting them?

Let's take a look at some of the factors that could support the case for rate increases.

Corporate earnings are strong

Current estimates call for 11.6% earnings growth for the S&P 500 (SNPINDEX: ^GSPC) in Q1 2026. If that number delivers, it would be the sixth consecutive quarter of double-digit year-over-year earnings growth for the index. Even better, small-cap earnings growth expectations are starting to improve as well.

Rate cuts are meant to support an economy that's deteriorating. If corporate earnings are already strong and in some cases accelerating, does that indicate economic weakness? Granted, the Fed's job isn't to keep corporate earnings growing, but it's also a sign that the economy really isn't in that bad of shape either.

Tariffs and geopolitics are inherently inflationary

Even though the Supreme Court recently struck down most of the Trump tariffs, we know that the administration is still looking for ways to apply some type of duty on foreign imports. Tariffs, of course, are paid by the U.S. importer and those higher costs often get passed on to the end consumer.

Geopolitical disruptions, such as the one we're seeing in Iran right now, usually come with some type of supply shock. Whether that's sanctions on oil, supply chain disruptions, or something else, that creates inflationary pressures that can't be solved with rate cuts.

Even though these things may be short term in nature, it wouldn't be wise to cut rates at a time when the inflation problem isn't solved and the current pressure on prices is higher, not lower.

Does the economy really need a boost?

Let's consider the high level numbers right now. U.S. GDP rose by 2.1% in 2025. The unemployment rate is 4.4%. The annualized CPI inflation rate is 2.4%. By historical measure, those are all numbers indicating a healthy, growing economy.

These macro fundamentals should make the argument for keeping policy rates right where they are. But with inflationary pressures tilting to the upside, the Fed could lean toward hiking interest rates next before lowering them.

The Fed may ultimately opt to lower rates before the end of the year. There's a lot that could happen over the next nine months. But I think investors would be wise not to dismiss the possibility that the Fed could need to hike rates at some point in the near future. The futures market is currently pricing in a 0% chance of this happening by year's end. I believe the odds are higher than that.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.