How the US energy shock and a more hawkish Fed changed the baseline

The escalation in the Red Sea caused us to revise our inflation forecasts up for the next two years and nudge our growth forecasts lower, and we see the Fed raising interest rates further. The economy should still hold up in 2027, but the odds have increased for some downside scenarios over the next 12 months.

We substantially shifted our oil price forecasts higher, and refinery capacity constraints mean prices of refined products, especially gasoline and diesel, have risen further. That boosts headline inflation and raises the risk of greater pass-through to food prices and core inflation next year.

For GDP, the biggest changes are in the details. Consumers and non-AI, non-oil business investment will bear most of the brunt, but that will be mostly offset by the ongoing surge in AI spending and a faster rebound in energy-related investment and production. Our expectation for the unemployment rate is little changed.

The balance of risks means we expect the Federal Reserve to deliver another rate hike this year, and the bias is toward more hikes than we assume. Rates will remain higher in the near term, and we revised our estimate of the long-run neutral fed funds rate up by 25bps, to 3.25%-3.5%.

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