The war between the United States, Israel and Iran is casting a shadow over a crucial week for central banks. The US Federal Reserve meets on Wednesday, followed a day later by the European Central Bank.
Oil prices have reacted nervously to the conflict in the Middle East, just as central banks believed they had largely brought inflation under control. ECB president Christine Lagarde sought to set the tone earlier this week. Europe, she argued, will not experience another inflation shock like the one that followed Russia’s invasion of Ukraine.
“We will do everything necessary to keep inflation under control and ensure that the French and the Europeans do not experience inflation increases like those we saw in 2022 and 2023,” Lagarde said in a television interview in Paris.
The ECB wants to avoid a renewed surge in energy prices once again dominating the inflation narrative. But that does not automatically mean the central bank will adjust interest rates.
Oil as a complicating factor
Oil prices briefly climbed above 120 dollars per barrel last Monday as markets priced in possible disruptions to energy flows from the Gulf region. Prices later fell back as traders reassessed the situation, before rising again above 100 dollars on Thursday.
At the same time, the G7 countries and the International Energy Agency agreed to release an unusually large volume of strategic oil reserves — up to 400 million barrels, roughly equivalent to four days of global consumption — in an effort to stabilize the market.
For investors, the key question is now less about the peak in oil prices than how long energy will remain expensive. Vincent Mortier, group chief investment officer at asset manager Amundi, expects the economic damage to remain contained.
“Even in our base scenario the shock will have an impact, but it will be manageable. We do not see a case where the world enters a recession or where hyperinflation makes a comeback,” he said during an investor call.
Markets move ahead of the ECB
Financial markets often react faster than the real economy. In bond markets this week, investors suddenly began pricing in a more hawkish ECB stance as a result of higher energy prices. Mortier believes that reaction has been exaggerated.
Markets have now priced in two possible rate hikes from the ECB. “We think that is too extreme,” he said.
The reaction highlights how sensitive markets remain to a new energy-driven inflation cycle. The eurozone is still a net importer of energy, while the United States has become the world’s largest oil producer.
As a result, higher oil prices can quickly translate into a classic supply shock for Europe: higher inflation combined with weaker growth.
Energy shock puts central banks in a bind
Economists warn that an oil shock can easily trigger stagflationary dynamics. Rabobank analysts calculate that in a severe scenario US inflation could rise to as much as 5.8 percent in 2026, while economic growth slows, although they consider a recession unlikely.
The policy dilemma is straightforward. “Monetary policy cannot solve both problems at the same time: higher inflation would require rate hikes, but weaker growth calls for rate cuts.”
According to Josh Hirt, senior US economist at Vanguard, such a situation puts both sides of the Federal Reserve’s mandate under pressure.
“Both sides of the Federal Reserve’s dual mandate fall under pressure,” Hirt said. “As long as it lasts, we would expect the Fed to have a bias toward inaction, although already elevated inflation will keep policymakers vigilant to potential changes in inflation expectations.”
Stagflation risk for markets
For financial markets, a prolonged disruption of energy transport through the Gulf region would create a classic stagflation mix, according to Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International.
Europe and Asia are particularly vulnerable because of their heavy reliance on imported energy, while the United States is relatively better insulated thanks to its higher domestic production.
“Bonds are not a great hedge here because the shock has a direct inflation impulse and can keep front-end pricing sticky even as growth deteriorates,” Ahmed said.
Uncertainty dominates
For investors, the bigger challenge may be the widening range of possible outcomes. Daleep Singh, chief global economist at PGIM, argues that markets are being forced to price a much broader set of scenarios.
“Markets are being asked to price a much fatter set of tails with very little reliable information about the likelihood of each,” he said.