Will central banks raise interest rates?
Markets are increasingly gripped by the fear that energy prices will remain elevated for the foreseeable future, or rise even further. Against that backdrop, the question is whether we are on the verge of rate hikes by the ECB, the Fed, and the Bank of Japan. This is how we assess the situation.
Start with oil. From the outbreak of the conflict in the Middle East, Iran’s strategy was clear: demonstrate to countries in the region that it can inflict significant damage, both materially and by cutting into their revenues from tourism and exports, while pressuring the rest of the world through higher prices for energy, helium, and fertilizers. The most effective lever here is the closure of the Strait of Hormuz.
By pursuing this strategy, Tehran aims to force a deal with all involved parties: Iran halts these actions in exchange for guarantees that it will be left alone going forward.
This marks a shift. Until recently, the Iranian regime sought to become the dominant power in the region through Hezbollah, Hamas, the Houthis, and ultimately nuclear capability. In recent months, however, the US and Israel have made it clear, militarily, that they will not tolerate this and are prepared to act decisively. The regime has therefore pivoted, relying more heavily on its remaining instruments.
When Israel and the US began their bombing campaign a few weeks ago, it became immediately clear that Iran cannot match them militarily. Yet by targeting regional countries and maintaining pressure on the Strait of Hormuz, Tehran retains a powerful weapon, not military, but economic. That matters, because most Western countries today are more sensitive to economic pressure than to military force.
The key question is how long Iran can sustain this approach, both the attacks on regional countries and the disruption of the Strait. Militarily, Iran’s capabilities have weakened significantly, making sustained attacks more difficult. That said, it may only take a handful of missiles per month to inflict meaningful psychological damage on nearby countries.
At the same time, most military experts agree that it would be extremely difficult for the US to fully prevent Iran from significantly disrupting the Strait of Hormuz.
The conclusion follows: there is a strong likelihood that energy, helium, and fertilizer prices will remain elevated for some time. The probability that the US and Israel reach a near-term agreement with Iran that would reverse this dynamic is low.
Which brings us to the next question: will higher energy prices push inflation high enough to force central banks to raise rates?
It depends. Higher energy prices initially drive inflation higher, but they also act as a drag on economic growth. That drag is amplified by the broader economic disruption caused by the conflict itself.
For that reason, central banks typically look through higher oil prices. The growth-dampening effect tends to pull inflation back down relatively quickly, making the inflation spike more of a one-off event.
This changes if the economy remains strong enough for higher energy, helium, and fertilizer costs to be passed through into final goods prices, and even more so if this feeds into higher wage demands.
Paradoxically, this means that the more sharply energy, helium, and fertilizer prices rise, the more likely it becomes that some central banks will respond with rate hikes, only to reverse course later as the growth impact takes hold. The sharper the price increase now, the sooner that reversal is likely to follow.
For a more concrete outlook on interest rates, we refer to next week’s Global Financial Markets report.
