Economic Compass
The butterfly effect:
Geopolitical shocks, policy uncertainty & the economic outlook
March 10, 2026
In the 1993 movie Jurassic Park, Jeff Goldblum famously illustrates chaos theory. He shows how tiny, imperceptible variations can send a drop of water on one’s hand in unpredictable directions.
The metaphor captures the spirit of the “butterfly effect” – how small shifts in a complex system can produce outsized and unpredictable outcomes. Iran’s shift from measured and even telegraphed responses, like we saw in the wake of the strikes on Iran in June 2025, to the escalation this year is an example.
That pivot has introduced a new level of uncertainty into an already evolving economic landscape. Recent attacks and threats to the Strait of Hormuz spiked oil prices and roiled financial markets.
The Strait of Hormuz is only 21 miles wide at its narrowest point. Yet only 6 miles of that chokepoint can be used to transport at least a fifth of the world's oil and natural gas supplies. Closing it amplifies the ripple effects of higher prices for the global economy.
That uncertainty is itself an economic force. It causes hesitation in making large spending decisions. Everything from home buying to hiring can be affected. We saw that last year with tariffs and the tension they caused for the Federal Reserve between rising inflation and unemployment.
This Economic Compass explores how those risks could reshape the outlook – from higher oil prices and rattled markets to renewed inflation pressures. Those shifts are occurring while the labor market continues to falter. That has put the Federal Reserve in a tough spot.
An oil shock against the backdrop of fiscal stimulus adds another layer of complexity. Much like we saw in the wake of the pandemic, those changes could trigger a longer-lasting bout of inflation, like the one which is still with us five years after it started. That will further delay rate cuts, regardless of who sits at the helm of the Fed.
2026 Outlook
Oil and financial market volatility
Chart 1 compares two scenarios for oil prices and what they mean for GDP growth:
Scenario 1 is our base case. The Strait of Hormuz is closed for several weeks, pushing oil prices temporarily above $100 per barrel. Some energy infrastructure is damaged, but the administration seeks an off-ramp ahead of the president’s scheduled summit in China on March 31. As tensions ease, oil prices retreat, though a risk premium lingers.
Scenario 2 shows the conflict extending for three to six months, with more significant damage to regional oil production and infrastructure. Oil prices temporarily surge above $130 per barrel until the Strait of Hormuz is fully reopened. Prices do not return to pre-conflict levels until late 2026/early 2027.
The problem is that oil production in the Gulf states is shutting down. It is easier to turn off that production than to ramp it up; the latter takes time and that is assuming only minor damage. A more drawn out conflict with cyber and terrorist attacks is probable. That adds to the unease and uncertainty that plagues boardrooms and households.
Chart 1: Higher oil prices take a toll on growth
Real GDP, percent change annualized rate
Scenario 1
Real GDP is forecast to rise 2.2% on a fourth-quarter-to-fourth-quarter basis, down from the 2.6% pace expected a month ago. Just under half of that 0.4 percentage point downgrade reflects higher energy costs. The focus is on fourth-quarter-to-fourth-quarter growth rather than annual averages, because that measure of GDP better captures momentum.
Oil prices climbed ahead of the attacks as markets priced in the risk of a disruption to oil supplies. Even if tensions ease, damage to oil fields will add to the time needed to ramp up idled production; that adds a persistent risk premium on oil prices.
The labor market has become a one-legged stool, with healthcare gains masking weakness elsewhere. That leg collapsed in February with a major strike in the healthcare sector. Those losses contributed to the drop in payrolls for the second time in three months.
At the same time, the labor force itself is growing more slowly. Aging demographics and tighter immigration mean fewer new workers are entering the job market. As a result, the economy now needs fewer new jobs each month to keep the unemployment rate from rising.
That dynamic helps explain why unemployment may edge up only modestly even as hiring stalls. Payrolls could turn briefly negative without triggering a rise in unemployment.
Consumers spend more cautiously. Turbulent financial markets and higher prices at the gas pump are straining the K-shaped consumer economy. Wealth effects cut harder on the downside than they lift spending on the way up. Foot traffic at luxury retailers evaporates on days markets sell off.
Housing wealth provides a cushion. Home values continue to rise nationally, albeit more slowly. While some pockets are seeing declines, the equity in homes remains substantial.
More importantly, the conflict coincides with a boost in tax refunds due to last year’s tax cuts. A portion of those refunds, which are just beginning to show up in consumer bank accounts, will be allocated to higher energy costs. The stimulus is sizable – about $130 billion – but the share flowing into discretionary spending is shrinking.
Separately, aging demographics are expected to buoy healthcare spending. The share of spending going toward healthcare has moved higher over the last year and is approaching the level we saw as we emerged from the pandemic.
Housing stays in a funk. Housing remains constrained, despite some drop in mortgage rates. Builder sentiment continues to weaken as higher material, labor, regulatory and land costs compress margins. More consumers refinanced than bought homes when rates fell at the start of the year.
The stock of unsold new homes is rising but in the wrong places. The existing stock of homes is getting older and needs more upfront repairs than it did previously.
Those shifts and the pent-up demand among those under 35 are increasing. The ranks of those under 35 and living with parents or a roommate hit a record in 2025; many would like to rent or buy. In response, the stock of housing is still two to four million short of demand.
That shortfall and a sharp slowdown in those able to move for a job is making an impact. Only affluent households can afford to relocate for better jobs. That adds to structural unemployment and spurs inequality at a time when consumers are unhappy with the status quo.
Affordability has become a rare bipartisan issue. State and local governments are making incremental progress by streamlining permits and allowing greater density, while federal efforts lag. Efforts to curb investor demand are unlikely to move the needle; investors account for only about 1% of sales, though they amplify price swings in the hottest post-pandemic markets.
AI carries business investment with a caveat. Spending on data centers and energy to power them remains robust. The problem is that much of the infrastructure needed to build data centers is imported, which is then subtracted from GDP.
Tariff waivers have lowered the cost for the tech behemoths but have not changed the arithmetic for the economy. Part of that investment shows up as a boost to growth and employment abroad instead of in the US.
Most economists remain skeptical that AI adoption is diffuse enough to account for economy-wide productivity gains. The changes are difficult to disentangle from layoffs aimed at shoring up cash flow or in response to uncertainty.
Recent research inside the tech behemoths reveals that AI boosts productivity growth but at a price. It intensifies work and expands the hours worked by remaining workers, which increases burnout.
Investment elsewhere is expected to remain subdued. New investment in the oil sector is constrained by consolidation, past oversupply and higher break-evens tied to tariffs. Producers need to see a sustained period of elevated prices to justify new projects; those projects need time to ramp up.
Inventories slowly rebuild. Inventories that were depleted after the front-running cycle we saw last year are being replenished. The Supreme Court's ruling against the emergency powers the administration used to levy much of its tariffs tipped off a front-running wave.
The administration moved quickly to impose a 10% tariff on all countries under Section 122 of the tariff code. The new tariffs are reshuffling winners and losers and making imports from Brazil and much of Asia cheaper. That has added to front-running.
Government spending remains constrained. Federal outlays will rebound temporarily as the government catches up on the blow to services dealt by the six-week shutdown. Government spending is poised to slow at the federal, state and local levels then, barring a major shift in defense outlays.
The latter requires an act of Congress, which is a heavy lift. The federal deficit will easily eclipse the size of the economy for the first time since WWII in 2026.
The trade deficit changes little. The trade deficit ended 2025 near its 2024 level. That was despite a significant increase in tariffs.
Supply chains were reshuffled to pivot toward lower tariffed economies, while tariff waivers helped tech companies to build data centers and buoyed imports. Exports stalled in response to weaker growth abroad, higher export prices and soft boycotts of US products.
Expect a similar pattern in 2026. Another front-running wave on imports has begun, as the administration decides whether to lift temporary tariffs to the 15% statutory limit. Exports continue to suffer from weaker growth abroad and high prices. Export prices accelerated at the start of the year, as tariffs on inputs more than offset the drag on prices due to a weaker dollar.
Separately, the United States-Mexico-Canada trade agreement (USMCA) is scheduled to be renegotiated this summer. The base case assumes we muddle through, but a more consequential shift in the terms of trade with our closest trading partners is possible. An end to the agreement would add six full percentage points to existing tariff rates.
Timing Risk. The administration has signaled a potential end to the escalation of tensions in the Middle East, which tipped off a relief rally in equity markets and a drop in oil prices. The outlook for oil prices still depends heavily upon reopening the Strait of Hormuz. The near closure is prompting major producers to consider idling more production. Once that happens, it could take weeks to get that production up and running again.
Scenario 2
Real GDP growth slows to 1.7% on a fourth quarter-to-fourth-quarter basis, down from 2.6% a month ago, with higher oil prices shaving three quarters of a percentage point from growth:
Consumer spending nearly stalls out over the summer only to rebound in the fourth quarter.
Housing loses ground until late in the year.
Business investment is buoyed by spending on data centers; we could see a small lift to investment in oil production.
Government spending is weak, barring a shift by Congress.
The trade deficit widens due to the disproportionate cost of higher oil prices on growth abroad relative to the US.
The unemployment rate moves up, which further stresses the Fed’s mandate to foster price stability and full employment. Fed officials will have to pick which side of the mandate poses a larger threat.
Risks. Chaos theory reminds us that the situation in Iran is extremely fluid; tensions could expand into a larger conflict. Cyber and terrorist attacks pose additional threats. Europe fears another refugee crisis.
Implications for inflation
Chart 2 compares the effects of the two scenarios on core PCE inflation, the Fed’s preferred measure because it captures spillovers beyond food and energy. The consumer price index (CPI) is less reliable at present: disruptions from the six-week government shutdown left gaps in the data that will suppress year-over-year readings well into 2026.
Core PCE inflation reaccelerated in December to its hottest pace since April 2024. January data – due later this week – are likely to exceed that high, keeping inflation well above the Fed’s 2% target. More concerning, price pressures are broadening, echoing patterns seen after the pandemic.
Service sector inflation has proven sticky and shown signs of accelerating while the full effects of tariffs have yet to hit. Core export goods prices, which typically lead core PCE by about six months, accelerated again in January. Those increases and a jump in the producer price index for goods prices, which captures profit margins, suggest more tariff-related inflation in the pipeline.
Refunds are unlikely to blunt inflation pressures. Customs and Border Protection estimate that $166 billion in tariffs was collected under emergency powers. The challenge is the paperwork and time it will take to issue refunds. A cottage industry on Wall Street has formed to get a portion of the tariffs back with interest for firms willing to sign away their rights on the tariffs. What was about thirty cents on the dollar last fall jumped to as high as seventy cents on the dollar after the ruling.
The administration has said it would raise temporary tariffs to their statutory limit of 15%. That would reshuffle tariff winners and losers. Imports from Brazil and much of Asia would be cheaper, but those from Europe could be more expensive. The higher tariff rate violates the agreement that the EU cut with the US. That ups the risk of retaliation by the EU, which has already paused a vote on the deal.
The remainder of tariffs will be levied by July, when the temporary tariffs lapse. The administration has fast-tracked investigations into more durable tariffs.
Risks. Much of the rise in prices due to tariffs is still ahead of us, while the trajectory of oil prices is uncertain. Every $10 rise in oil prices adds twenty-five cents to prices at the gas pump, with larger spillovers to jet fuel, diesel and fertilizer. The effects ripple through the goods and services sectors.
Separately, oil prices tend to be their own best cure. They destroy demand, which can act as an offset to even higher prices as long as inflation expectations are anchored. What we do not know is whether the anchor line will hold.
Chart 2: Inflation is higher for longer
Core PCE price index, excludes food and energy, percent change y/y
A sidelined Fed
Chart 3 shows the path of the fed funds rate under the two scenarios. In Scenario 1, rate cuts are delayed until September and December; in Scenario 2, they are pushed into 2027.
This is not the 1970s. Gasoline accounts for a smaller share of consumer spending – but its signaling power is outsized. Highly visible gasoline prices play a larger role in shaping inflation expectations than almost any other price.
That risk is amplified by timing. The economy is now in its fifth year of elevated inflation. Fiscal stimulus is landing just as oil prices are rising again. Consumers expect more inflation than they did before tariffs. Higher energy prices could reinforce those expectations and unmoor inflation expectations, which are already looking less tethered to an anchor than they were in the 2010s.
The Fed is left with few good options. Rate cuts risk entrenching inflation, while holding steady may not be enough to boost employment. The incoming Fed Chair will have limited room to maneuver at the start of his term; he must first convince his colleagues and financial markets of his inflation-fighting resolve.
Risks. The Fed might have to wait even longer to cut rates; a rate hike is not out of the question. The minutes reveal that at least some Fed officials were weighing that option prior to the spike in oil prices, which carries with it more stagflation risks than tariffs.
How long will Treasury bond yields rise?
The 10-year Treasury yield has climbed alongside oil, even as February employment data softened. That is a reminder that markets are pricing inflation and risk premia, not just growth.
Those shifts are occurring while the composition of Treasury bond buyers is shifting. Institutional buyers (other central banks and pension funds) are yielding ground on the margin to hedge funds. The latter are more leveraged and sensitive to changes in prices.
The EU has threatened using its Anti-Coercion Instrument – a package that could include tariffs, curbs on US firms operating abroad and sales of U.S. assets, including Treasuries. That “trade bazooka” would land on a market already showing strain.
Risks. Treasury bond yields could rise instead of fall, depending upon how much the world continues to trust the US amid yet another conflict in the Middle East. The threats the US made toward Greenland, a territory of Denmark, were considered a line in the sand.
Chart 3: Fed sidelined longer
Federal funds rate, quarter average
Bottom Line
The butterfly effect offers a useful reminder: in fragile systems, small shifts can generate outsized and unpredictable consequences. In the Middle East, even limited tactical changes now carry the potential to alter economic outcomes well beyond the region.
That uncertainty has become an economic force in its own right. It raises risk premia and slows decision making across households and boardrooms, from hiring and capital spending to large discretionary purchases.
This crisis hits close to home. I escaped the World Trade Center on 9/11 and learned first-hand how long the tail risk can be. I found my body was riddled with cancer in the middle of a pandemic due to exposure to toxins all those years ago. Hence, my humility in forecasting the outcome of the current crisis. All we know for sure is that nothing is a sure thing. Be kind; pay it forward.
Shutdown disrupts growth
Real GDP expanded at a subdued 1.4% annual rate in the fourth quarter of 2025. Consumer spending slowed after accelerating over the summer. Housing activity continued to contract. Business investment picked up in response to the ongoing boom in data center construction. Inventories rebuilt after draining rapidly over last Spring and Summer. Government spending shaved nearly one full percent from growth due to the services lost during the six-week government shutdown. The trade deficit widened, as imports picked up in response to data center inputs while exports fell.
Prospects for the first quarter of 2026 are only slightly better. Real GDP is expected to grow 2%, significantly weaker than just a month ago. Consumer spending slowed in response to harsh winter weather, which kept many homebound in January and February. Higher prices at the gas pump are another headwind, despite a surge in tax refunds which will boost spending.
Business investment is poised to accelerate, with backlogs on data center building. Inventories will continue to rebuild. Government spending will add back nearly one percent to growth, as services delayed by the shutdown are fully recouped. The trade deficit is expected to widen. Uncertainty on where tariffs will land after the Supreme Court's decision has spurred front running.
The Fed stays uncomfortably on the sidelines. Soaring oil prices, tariff-related price hikes and signs that service sector inflation is accelerating have left the Fed on the sidelines. It needs to derail the inflation that emerged after the pandemic. The path to a soft landing has narrowed, given the rise in both inflation and unemployment.
Economic Forecast — March 2026
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