The dilemma for central banks
The great dilemma for central banks is that excessive inflation is largely caused by rising oil and fuel prices. According to theory, a central bank should not respond to such a negative supply shock with rate hikes. First, a higher interest rate will not lead to greater supply of oil and fuel. Second, higher energy prices are already slowing economic growth, which puts downward pressure on inflation over time. An additional rate hike on top of that could lead to overkill.
However, central banks fear that this theory does not hold in the current environment. The current negative supply shock is, after all, the latest in a relatively short series (following Covid and the war in Ukraine), and another one already appears to be forming (disappointing harvests due to drought and a super El Nino). This series of negative supply shocks could ultimately lead to higher long-term inflation expectations, giving inflation a more structural character. In addition, rapidly rising AI investment, persistently high government deficits, and an ageing population mean that the economy and labour market are being slowed less than expected by higher energy prices. As a result, the economy can better absorb the higher prices stemming from the supply shocks. For now, energy prices look set to rise further.
Geopolitics is driving up energy prices
Ukraine and Russia are trying to bring each other to their knees economically by bombing each other's energy facilities and agricultural export infrastructure. As a result, many Russian refineries have been shut down and the country can export less oil. The same applies to agricultural exports via the Black Sea (both Ukraine and Russia are major exporters of agricultural goods). Russia now has to import fuel, even though it has traditionally been a major exporter, particularly of diesel.
Tensions in the Middle East are rising as the US and Iran continue to exchange fire and restrict oil transit through the Strait of Hormuz. The risk is also increasing that the Houthis will disrupt oil shipments through the Bab el-Mandeb Strait, making it harder for Saudi Arabia to export oil via ports on the Red Sea. The prospect of lower oil exports from the Middle East comes at a time when oil inventories have already shrunk significantly.
Iran sees its negotiating position strengthened now that the US, heading into the midterms, would prefer to avoid a further rise in oil prices. By ramping up pressure now, Iran hopes to extract more concessions from the US. The US, for its part, hopes the economic blockade will force Iran to its knees. The Iranian population is suffering increasingly under this blockade, but Iran's rulers are unlikely to be swayed by that. Their own survival is at stake, and they believe they currently hold the stronger hand.
Trump is stepping up pressure on Ukraine not to bomb Russian refineries. But Ukraine, which itself is increasingly under strain from Russian missile attacks it cannot defend against, is unlikely to pay much heed. Creating fuel shortages is probably Ukraine's most effective way of pushing Russia to negotiate seriously for peace.
The only route left toward a sharp drop in oil and fuel prices therefore appears to be a TACO (Trump Always Chickens Out), whereby Trump unilaterally ends the war with Iran and the Strait of Hormuz reopens to shipping under conditions set by Iran. Pressure on Trump to deliver a TACO is increasing, now that his popularity has fallen sharply because of the Iran war and long-term interest rates have risen to levels at which many analysts see the negative impact of rates on equity prices intensifying. But a TACO would also be seen as a defeat for the US and would significantly diminish the deterrent effect of the US military (and with it, US influence over other countries).
There is therefore a strong chance that Trump will not deliver a TACO for the time being, causing energy prices to rise further, speculation about additional rate hikes by central banks to increase, and long-term interest rates to climb further as a result. Over the coming months, we expect this to translate into growing downward pressure on equity prices. A TACO would then become likely after all.
