The Case for 4% Inflation and Why Equities Are Likely to Go Lower

[OPINION]

Note: This will be one of my longer notes, but I think you’ll find it worth the read and I look forward to your feedback.

In what will be his final press conference, Jerome Powell communicated the FOMC’s decision to hold interest rates steady at 3.5%–3.75% for the third consecutive meeting. While the decision itself was not surprising, one could argue the vote to arrive at that decision, was.

Unlike previous meetings, it was unusually fractured. Four members dissented (the most since 1992), amidst a clear and obvious disagreement over how to navigate an inflationary environment that has grown far more complex than most market participants anticipated at the start of the year. So far, we have had to deal with the ongoing effects of Liberation Day tariffs, the wars in Iran and Ukraine and fiscal uncertainty. And we’re still in Q2.   

And so, while the FOMC's latest statement conceded the obvious when it declared the Middle East war was "contributing to a high level of uncertainty about the economic outlook," a meaningful share of the market still appears to be filing the conflict under the same heading as post-Liberation Day tariffs: a temporary disruption with negligible long-term inflationary consequences.

This underestimates what is happening.

To put it bluntly, it is clear to me the cocktail of risks that cloud the outlook means that inflation in the United States is likely to reach 4% or higher in the coming months, and that this trajectory, combined with a hawkish central bank, rising fiscal deficits, and elevated equity valuations, sets the stage for a meaningful correction in stock prices and no relief in sight for issues such as the affordability crisis Washington is so fond of decrying. The logic is not complicated, but the confluence of forces driving it is unusually powerful, and I think it deserves a clear articulation.

The War Premium Is Not Transitory

We are now two months into the military campaign against Iran, and the economic fallout is spreading. The effective closure of the Strait of Hormuz has seen energy prices rise, with Europe and Asia facing growing energy crises. While the U.S. is largely energy independent with respect to oil and gas, both are globally priced commodities. Whether the U.S. is energy-independent or not, is largely irrelevant. If 20% of the world’s oil supply cannot get to where it needs to go, scarcity lifts prices. That is what we are seeing.

The March CPI report tells the story in numbers: headline inflation jumped to 3.3% year-over-year, up from 2.4% in February, driven by a 10.9% surge in energy costs and a 21.2% spike in gasoline prices in a single month. While core CPI (excluding food and energy) rose a more restrained 2.6%, this metric offers false comfort. Oil shocks have both an immediate and a delayed effect. Gas prices spike first. Then the second-order effects ripple through the economy. Those include shipping costs, airline fares, manufacturing inputs, and eventually food prices. As higher energy costs work their way through supply chains, they eventually find their way to consumers, who subsequently reduce spending or search for substitutes.

This will sound familiar if you’ve taken a basic Economics course.

Even under an optimistic scenario where the ceasefire holds and the Strait gradually reopens, research from the Federal Reserve Bank of Dallas estimates that the Iran war could add 0.6 to 1.1 percentage points to headline PCE inflation by the fourth quarter of 2026 alone, depending on the duration of the disruption. Multiple economists now project headline inflation could reach 4% by the end of the year, which is double the Fed’s stated target.

Even if the geopolitical situation improves, the inflationary damage has been done, and it will linger.

The Fed Is Constrained

Under normal circumstances, the Federal Reserve would respond to accelerating inflation by tightening monetary policy (raising rates). But the current environment is anything but normal. The Fed is currently caught between two mandates pulling in opposite directions: inflation is rising, but the labor market is softening. Raising rates to fight energy-driven inflation would risk tipping a slowing economy into recession. Cutting rates to support growth would pour fuel on an already hot inflation fire. So the Fed does neither. Instead, it holds. Markets are now finally pricing in zero rate changes for the remainder of 2026- a far cry from the two to three cuts that were expected at the start of the year.

To those who believe Kevin Warsh will drive cuts through, note that he is one of multiple members of the FOMC. While the Chair is influential, he/she does not have the ability to do as they please. While there are some who believe the incoming Chair is more ideologically aligned with the administration’s preference for lower rates, Mr. Warsh surely understands that a cut could add to inflationary pressures rather than contain them, since a cut would juice equity prices and asset prices, overall. But perhaps even more important is the idea that should the market surmise that the Fed is being controlled by the White House (i.e. a deterioration of Fed independence), markets could lose confidence in the Fed’s willingness or ability to fight inflation, which itself becomes inflationary.

Inflation Checklist

The Iran war is the most visible inflationary force, but it is not the only one. Several other factors are compounding the problem simultaneously:

• Tariffs. The Supreme Court struck down the administration’s “Liberation Day” tariffs, but the White House has pursued alternative levies under different legal authority. Import duties continue to raise input costs for businesses and consumer prices for goods, with tariff-sensitive categories like apparel and household items seeing notable increases.

• Fiscal expansion. The One Big Beautiful Bill Act is injecting stimulus through investment incentives and full expensing provisions, while adding demand to the economy precisely when the supply side is constrained. Translation: larger deficits.

• Supply chain disruptions. The closure of the Strait of Hormuz has strangled not just oil but also liquefied natural gas exports and critical chemical inputs. This has downstream effects. Furthermore, shipping costs by rail, air, road, and sea have all risen as carriers pass higher fuel costs to customers.

• Food prices. While grocery prices were flat in March, this is a lagging indicator. Higher diesel costs will eventually flow into food distribution. Beef prices are up nearly 20% year-over-year, with coffee, sugar, and nonalcoholic beverages are all projected to see significant price increases through 2026. Even takeout is running at +3.8% annually.

Altogether, these forces create an inflationary environment that is broader and more persistent than the headline energy spike alone would suggest. The case for 4% inflation is not a prediction about one month’s CPI print. Instead, it is a structural argument about the convergence of energy shocks, fiscal policy, trade policy, and supply chain fragility all arriving at the same time.

Why This Means Lower Equities

The equity market entered 2026 at historically elevated valuations. The S&P 500 completed a third consecutive year of double-digit gains, and a few Wall Street analysts were posting year-end targets above 8,000 (as crazy as that now sounds), thanks to continued AI-driven earnings growth, further Fed rate cuts, and a benign inflation backdrop.

Every one of those assumptions is now under pressure.

First, rate cuts are off the table. Markets entered the year expecting two to three 25-basis-point reductions. Instead, the Fed has held steady for three consecutive meetings, and futures markets are now pricing no changes through year-end. Without the tailwind of lower rates reducing the discount applied to future earnings, one of the primary supports for elevated valuations has evaporated.

Second, corporate margins face compression. Higher energy prices are not just a consumer problem. They raise transportation costs, manufacturing inputs, and operating expenses across virtually every sector. Airlines have already hiked baggage fees, United and Lufthansa (among others) have announced route eliminations/flight cancellations, and shipping surcharges are being passed through supply chains. Companies that absorbed tariff costs in 2025 now face an additional energy cost shock simultaneously.

Third, rising bond yields create competition for equities. Higher inflation expectations push up long-term Treasury yields, making fixed income more attractive relative to stocks. When the 10-year yield rises, it raises the discount rate for future cash flows, mechanically reducing the present value of equity prices (i.e. “repricing”)

Fourth, consumer spending the engine of the U.S. economy is under strain. Real earnings fell 0.6% in March as wage growth failed to keep pace with surging prices. Gas prices above $4 per gallon and rising grocery costs squeeze household budgets, particularly for lower and middle-income consumers who are already stretched. Those tax refunds the Treasury has been touting? Gone, as long as energy costs continue to act as a regressive tax on the consumer.

To Summarize

Equity markets are priced for a world where most things go right. The current environment is one where many things could go wrong simultaneously. More than half the stocks in the Russell 3000 are already down 20% or more from their highs, a statistic that the headline index obscures because of its concentration in a handful of mega-cap technology names.

This does not mean a crash is imminent. Markets can absorb bad news for extended periods, especially when AI-driven earnings growth in the technology sector provides a counterweight. But that’s until it can’t and the balance of risks shifts decisively to the downside. For investors, this environment calls for caution and a recognition that the inflationary forces at work today are neither transitory nor easily contained.

The market has been priced for perfection. What it is getting is 4% inflation, a Fed that is showing itself to be increasingly hawkish (and at odds with the executive branch), and a new war in the Middle East with no end in sight.

That is not a recipe for higher stock prices.

Disclaimer: The content contained herein is provided for general informational purposes and does not constitute a recommendation, offer, or solicitation to buy or sell any securities. The content reflects the writer’s views and analysis as of the time of writing and are intended to support investment decision-making by providing an analytical perspective and context. The content does not address every factor relevant to any particular investor’s circumstances, and investors should evaluate their own facts and circumstances before making any investment decision. Past performance is not indicative of future results.