The resurgence of the United States-Iran conflict has reignited fears of a global inflation shock, forcing central banks to reconsider their interest rate paths as higher energy prices threaten to prolong price pressures and weaken economic growth.
Markets had been positioning for a softer inflation environment after a fragile ceasefire between Washington and Tehran briefly eased concerns over oil supply disruptions.
However, renewed military escalation has pushed crude prices sharply higher, reviving the prospect of a stagflationary shock similar to previous energy crises.
The conflict has placed central banks in a difficult position: raising rates could help contain inflation expectations but risks worsening already fragile growth conditions.
The Reserve Bank of Australia (RBA) is among those facing renewed pressure. The Guardian reported, citing ANZ forecasts, that market pricing now suggests the probability of a rate increase has almost doubled, with traders assigning a nearly 30% chance of a hike on 12 August, up from 16% two weeks earlier.
The probability of a rate increase by November has risen to 80%, according to the forecasts.
Brent crude has climbed around 23% over the past two weeks, approaching US$90 a barrel as investors price in the possibility of prolonged supply disruptions.
Australian motorists have already seen fuel costs rise, with diesel prices increasing by around 40 cents per litre in July to approximately $2.10 per litre in major east coast cities, while unleaded petrol prices have risen by around 25 cents to $1.75 per litre.
Luke Yeaman, Commonwealth Bank’s chief economist, warned the conflict could deliver another stagflationary shock to Australia’s economy.
“In the current dynamic, we believe this will drag on for at least several weeks and possibly longer,” Yeaman said.
However, Yeaman said a sustained rise in oil prices would create a difficult policy dilemma by simultaneously increasing inflation and slowing economic growth.
“If we see a prolonged closure of the strait and a big jump in oil prices, that will feed through to higher inflation, but it will also slow growth. In the short term that could mean the case for one further rate hike is higher.
“But calls for multiple … rate hikes are a little overblown.”
Oil shock revives stagflation fears
The renewed conflict has also pushed global markets to reassess the inflation outlook.
Reuters noted that while the initial shock from the U.S.-Israeli strikes on Iran may not be repeated unless there is a major escalation such as a ground invasion, geopolitical risk has returned to investors’ focus.
"Central banks and financial markets are again facing the negative supply shock scenario, which they had hoped to have escaped when the US and Iran signed the interim deal in mid-June. Stagflationary impulses are back," Barclays strategists wrote.
The concern is that the current environment is more fragile than earlier in the conflict. Oil inventories are lower, refining capacity remains constrained and disruptions to shipping routes could create additional pressure on global energy markets.
Daniel Hynes, senior commodity strategist at ANZ, said the decline in oil prices during the ceasefire failed to fully reflect vulnerabilities across the supply chain.
“The $US100-a-barrel mark would potentially be within sight if we are here in a few weeks’ time and things have gotten worse.”
Fed rate cut hopes fade as inflation risks return
The Federal Reserve is also facing renewed uncertainty as energy prices threaten to slow progress on inflation.
Fed Vice Chair Philip Jefferson said policymakers may need to reconsider their stance if inflation fails to continue declining.
"This policy stance should continue to support the labor market while allowing inflation to resume its decline toward our 2% target as the effects of past tariffs and energy prices pass through completely," Jefferson said.
However, he warned that persistent inflation could require tighter policy.
"That said, in a scenario where actual inflation does not start to cool down soon, I believe that it could be appropriate to reconsider our current policy stance to ensure we fulfill our commitment to deliver price stability."
Jefferson said the Middle East conflict and higher fuel prices could increase inflation risks by affecting expectations.
"The quick succession of shocks raises the risk that inflation becomes entrenched and inflation expectations become unanchored," he said.
The renewed inflation threat has reduced expectations for Federal Reserve rate cuts, while markets have increasingly priced in a higher-for-longer interest rate environment.
ECB and Asian central banks turn more hawkish
Europe is also facing pressure from higher energy costs.
A Reuters poll found economists increasingly expect the European Central Bank (ECB) to raise rates again in September as renewed energy inflation threatens to slow progress toward its 2% inflation target.
A 70% majority of economists surveyed expected another rate increase this year, compared with around 60% in the previous poll.
Chris Scicluna, head of economic research at Daiwa Capital Markets, said energy prices could force policymakers to act.
"Gas prices are significantly higher and electricity power prices are higher as well. The ECB is going to have to take account of this when it next updates its forecast in September. But for now it will judge there's no urgency for it to raise rates just yet again."
Asian central banks are also facing diverging policy challenges.
The Bank of Korea recently raised rates for the first time in three-and-a-half years, increasing its benchmark rate by 25 basis points to 2.75% as growth momentum and inflation concerns strengthened.
Meanwhile, analysts expect Asian monetary policy paths to increasingly diverge depending on domestic inflation pressures, currency weakness and reliance on imported energy.
Policy dilemma: inflation control versus growth protection
J.P. Morgan Asset Management said the conflict has significantly altered expectations for central bank policy, with energy shocks increasing inflation risks while weaker growth complicates the response.
The investment firm noted that central banks are likely to balance inflation risks against domestic economic conditions rather than simply follow the Federal Reserve’s direction.
"Energy shocks have lifted global inflation risks, but central bank responses will vary due to local growth challenges, capital flows, and currency reactions."
For Australia, the risk is that higher fuel costs arrive while households are already under pressure from previous monetary tightening.
Yeaman warned that economic growth could slow sharply if the conflict escalates and the Strait of Hormuz remains disrupted.
“Were you to see a serious escalation in the conflict and a prolonged closure of the strait [of Hormuz], then growth could slow much more sharply.”
With oil markets once again becoming the key transmission channel between geopolitics and inflation, investors are watching whether central banks can avoid another cycle of tightening without triggering a deeper slowdown.
