Hiking Into a Supply Shock: The Warsh Fed, Sticky Inflation and the December Decision

Twelve months ago the debate was about how fast central banks could cut. Today the Federal Reserve and the European Central Bank have both turned to tightening, in the middle of an energy shock that neither can solve. The December meetings of both institutions will show whether policymakers treat the oil shock as transitory or as a threat to inflation expectations.

Where the Fed Stands

Under Chair Kevin Warsh, the Federal Reserve raised its policy rate in September, its first hike in three years, taking the target range to 3.75% to 4.00%. At its meeting on 28 October the Committee held rates by a 10-2 vote, with Governor Lisa Cook and Cleveland Fed President Beth Hammack dissenting in favour of a further 25 basis point increase. The statement upgraded the assessment of economic activity from solid to strong, and the Fed also announced that it will hold fewer policy meetings from 2027.

The data since then have not made the decision easier. October's consumer price index, published on 10 November, rose 0.4% on the month against expectations of 0.3%, and core prices rose 0.3% against 0.2%. Because the Bureau of Labor Statistics could not collect prices during the 2025 government shutdown, the October report carries no annual rate; the last available readings, for September, were 3.7% for headline and 2.6% for core inflation. Over three months, core inflation is running at an annualised pace of roughly 3.8%. Payrolls rose by 165,000 in October, more than twice the consensus, and third-quarter GDP grew at an annualised rate of just under 3.5%.

Why This Is Harder Than 2022

In 2022 the Fed was behind the curve on demand-driven inflation, and raising rates was the obvious remedy. In 2026 the main impulse is a supply shock: energy prices rose about 20% over the twelve months to September, driven by the war with Iran and the disruption to shipping through the Strait of Hormuz. Monetary policy cannot reopen a shipping lane. What it can do is prevent a one-off rise in the price level from becoming a persistent rise in inflation.

The case for a December hike rests on breadth. Food and services prices rose firmly in October, and services inflation is running at about 3% a year. The case for patience rests on the oil market: Brent has fallen sharply since the midterm elections on hopes of a negotiated end to the conflict, and an energy reversal would pull headline inflation down mechanically in the first half of 2027. Before the election, futures markets priced a probability of around 79% for a December hike, and market commentary read the hotter October CPI print as reinforcing that expectation.

The Bond Market's Own Problem

Long-term yields reflect more than the policy rate. The ten-year Treasury yield reached roughly 5.3% at the end of September, its highest level in nearly two decades, before falling by about 0.4 percentage points into early November as investors moved from equities into bonds during the AI selloff. The supply backdrop remains heavy: the U.S. Treasury faces roughly $13.6 trillion of maturities over the coming year.

The midterm result adds a fiscal dimension. With Democrats controlling both chambers of Congress from January and the President retaining his veto, most analysts expect gridlock on taxes and spending. For bond investors that is a mixed outcome: it makes large new fiscal packages less likely, but it also makes a credible consolidation less likely, and it raises the risk of confrontations over appropriations.

Europe: The Same Shock, a Weaker Starting Point

The ECB faces the energy shock as a net importer. It raised its deposit rate twice in 2026, to 2.50% in September, and held it on 29 October, when euro area inflation stood at 3.8% with energy prices up 18.9% on the year. The Governing Council discussed another increase and chose to wait for data; markets priced a hike in December with a probability of around two thirds. Christine Lagarde also announced that she will step down early, on 7 February 2027, which adds a leadership question to an already difficult policy choice. The euro traded near its lows of the year around 1.11 against the dollar.

Scenarios for the Next Three Months

Hike and hold. The Fed raises rates in December and signals a pause. Front-end yields rise, the curve flattens, and the dollar firms against energy importers. Equity valuations remain under pressure, particularly in long-duration growth sectors.

Energy-led pause. A credible agreement on Hormuz pulls oil lower, and the Fed holds in December while keeping a tightening bias. Breakevens compress, the curve steepens modestly, and equity breadth improves.

Second-round inflation. Services and wage data accelerate despite lower oil. The Fed is forced into a sequence of hikes in 2027, long yields retest their September highs, and both equities and bonds lose value at the same time, as in 2022.

Implications for Portfolios

The scenario that hurts multi-asset portfolios most is the third, because it breaks the negative correlation between equities and government bonds on which most balanced portfolios rely. In such regimes, diversification has to come from risk management rather than from asset allocation: reducing equity exposure when tail risk rises and holding short-dated instruments rather than long duration. That is the logic of SPY3, which moves from US large-cap equities into short-dated US Treasuries when its Value-at-Risk veto is triggered, rather than relying on long bonds as a hedge.

For institutional investors, the practical conclusion is to stress-test portfolios for a world in which inflation stays above 3% for longer and central banks cannot come to the rescue, rather than for the falling-rate environment that dominated the previous decade.