Deutsche Bank Warns: Fed Rates Underestimated by 100 Basis Points, Iran Is the Key Variable

Situation. He calculated using multiple standard frameworks such as the Taylor rule, equilibrium method rule, and first-order difference rule, and the conclusions are highly consistent: the current federal funds rate is below the reasonable level under all frameworks.

The specific figures are quite striking. With core PCE inflation at about 3.2%, unemployment rate at 4.3%, and the estimated real neutral interest rate at 1.1%, both the Taylor rule and the equilibrium method rule point to a policy interest rate in the 4.7% to 4.8% range, more than 100 basis points higher than the current level. If using Deutsche Bank's own higher estimate for the neutral rate, the gap will further widen to about 150 basis points. Combining various rules and assumptions, the federal funds rate is approximately 50 to 160 basis points below the reasonable level.

Even when replacing current data with forward-looking forecasts, the conclusion remains largely unchanged. By substituting the end of 2026 forecasts from Deutsche Bank, the Federal Reserve Economic Projections Summary, and Bloomberg consensus expectations into the Taylor rule, the current policy still appears accommodative, with a gap of about 30 to 75 basis points. Luzzetti characterizes potential future rate hikes as "prudently reversing insurance" rather than a policy shift.

On this basis, Deutsche Bank further incorporates the Iranian situation into the analytical framework, pointing out that the trend of oil prices will directly affect the degree of anchoring of inflation expectations, and thus determine whether the Federal Reserve needs to resume rate hikes. The report speculates on three scenarios around Iran's ceasefire negotiations.

The first scenario is the conclusion of a peace agreement. The Strait of Hormuz reopens, oil prices continue to fall, and pressure on the Federal Reserve to raise interest rates in the near future is significantly reduced. Deutsche Bank expects the new Federal Reserve Chairman Warsh to treat inflation pressures as temporary disturbances and choose to "look through" them. However, the bank also warns that the risk of rate hikes has not disappeared; if inflation remains high after the elimination of tariff and energy pressures, the risk of policy rate increases is more likely to be realized in 2027.

The second scenario is the breakdown of negotiations and a stalemate. Deutsche Bank characterizes this as the "highest rate hike risk" among the three scenarios. The Strait of Hormuz remains closed for a long time without further escalation of the conflict, oil prices remain high, leading to core inflation, the risk of inflation expectations de-anchoring, and the economy has not yet been damaged enough to let the Federal Reserve stand idle. The bank believes it is unlikely that the Federal Reserve will take rate hiking action before September, but the possibility of multiple rate hikes in 2026 should not be ruled out. Notably, Federal Reserve Governor Waller has recently stated that if inflation does not fall soon, rate hikes may be a reasonable choice.

The third scenario is an escalation of the conflict. Deutsche Bank believes this does not necessarily mean unilateral rate hikes, but brings a two-way policy risk. A sharp rise in oil prices will increase inflation expectations, but will also impact the real economy and the labor market. The ultimate policy direction will depend on the sequence of realization of the two risks: if inflation expectations de-anchor first, strong tightening will be needed; if the labor market shows cracks first, the Federal Reserve may shift to cutting rates.

Overall, Deutsche Bank's analysis reveals a clear chain of logic: the Iranian situation determines oil prices, oil prices determine the nature and duration of inflationary pressures, and whether inflation expectations de-anchor will ultimately determine the Federal Reserve's policy space. The most attention-worthy signals at present include: substantive progress in ceasefire negotiations, whether Brent crude oil can stabilize below $100 per barrel, and whether Federal Reserve officials begin to remove rate cut inclinations or openly discuss the possibility of rate hikes.