Central banks face policy trap as Iran war drives inflation shock just as growth momentum fades

<p>The war in Iran has thrust the world's major central banks into a familiar— and deeply uncomfortable — position.</p>
<p>Just as inflation pressures were easing and policymakers were preparing to move toward rate cuts, a surge in energy prices (BZ=F, CL=F) driven by disruptions in the Middle East is complicating the global outlook. The result is a worsening policy dilemma: rising inflation risks on one side, and slowing economic growth on the other.</p>
<p>That trade-off will be in focus this week as the Federal Reserve, the European Central Bank, and the Bank of England all hold closely watched policy meetings. Switzerland's central bank is also set to decide on rates.</p>
<p>Economists broadly expect all four institutions to keep borrowing costs unchanged, adopting the wait-and-see stance Fed Chair Jerome Powell has emphasized over the past year. But the renewed energy shock — tied to attacks on infrastructure and shipping disruptions that have roiled global oil markets — is already shifting expectations about how quickly policymakers can move to support growth.</p>
<p>"The timing of the conflict could hardly be more complicated for global central banks," Capital analyst Daniela Hathorn wrote in a recent note. "Officials must decide whether to look through the shock as temporary — or respond more aggressively to its inflationary implications."</p>
<p>Rising fuel costs tend to lift headline inflation and can feed into broader price pressures through more expensive goods and services, strengthening the case for keeping interest rates elevated or even tightening policy further.</p>
<p>At the same time, more expensive energy acts like a tax on households and businesses by squeezing disposable incomes and raising operating costs. That dynamic can slow consumption, investment, and overall economic growth — conditions that would normally argue for lower borrowing costs.</p>
<p>"The war increases both the risk that earlier rate cuts will be needed to address labor-market softening and the risk that a higher inflation path will delay cuts," Goldman Sachs chief US economist David Mericle wrote in a recent client note.</p>
<p>Bond markets have already begun to reflect that tension. Yields on short-dated Treasurys such as the US two-year — which closely track expectations for Federal Reserve policy — have moved higher in recent weeks as traders push back the timing of rate cuts in response to renewed inflation risks. The two-year yield is up by roughly 25 basis points over the past month.</p>
<p>When the Fed concludes its meeting this week, officials are widely expected to leave the benchmark policy rate in a 3.5% to 3.75% range while acknowledging heightened uncertainty about the economic outlook. Updated projections are likely to reflect both stronger near-term inflation pressures and somewhat weaker growth as elevated energy costs feed through the economy.</p>
<p>That same dynamic is playing out even more forcefully across Europe.</p>
<p>Like the Fed, the European Central Bank is also expected to keep policy steady even as the energy shock threatens to lift headline inflation while weighing on activity. In return, longer-term government bond yields in Europe have been volatile as investors weigh the inflationary impact of higher oil prices against rising risks to eurozone growth.</p>
<p>"We are in an economic situation that's different … and we have a greater capacity to absorb shocks," Lagarde said. "We will do all that is necessary to ensure inflation is under control."</p>
<p>At the Bank of England, officials face what may be an even more stark backdrop. Rising fuel costs have increased upside risks to inflation, reducing the likelihood of an imminent rate cut despite signs of a cooling labor market and stagnating GDP growth.</p>
<p>Even Switzerland — where inflation has remained comparatively subdued — is seeing its outlook shift as higher energy prices feed into consumer costs. The Swiss National Bank is also expected to remain on hold, though economists say the balance of risks has tilted toward higher inflation if the shock intensifies.</p>
<p>The broader economic impact of the conflict is already expected to hit both growth and inflation globally. Analysts at Goldman Sachs estimate that higher oil prices could shave several tenths of a percentage point from global growth over the next year while lifting headline inflation across major economies.</p>
<p>During the energy crisis that followed Russia's invasion of Ukraine, higher fuel costs eventually spilled over into wages and core inflation, forcing policymakers to tighten aggressively even as growth slowed.</p>
<p>This time around, however, global economies should also be better positioned to handle rising energy costs than they were in 2022, Michele Morganti, senior equity strategist at Generali Asset Management, said.</p>
<p>"We see major differences versus 2022," Morganti said. "So far, the energy price shock is more contained, the global economy on a better footing, and central banks, [which were] very accommodative in 2022, are already in neutral territory."</p>
<p>Still, the longer oil prices remain elevated, the greater the risk that inflation expectations could become harder to contain. That leaves central banks navigating a narrow path between supporting weakening economies and preventing another inflation surge — a balancing act likely to define global monetary policy in the months ahead.</p>
<p>"The supply shock is resulting in a market lowering growth expectations and increasing inflation expectations," Capital analyst Kyle Rodda wrote in emailed commentary. "That's manifesting in doubts about future profitability and the path forward for global interest rates."</p>
<p>Rodda added, "The markets are pricing in a world where rates are higher than they would otherwise have been — and heading in a far more uncertain direction."</p>
<p>Jake Conley is a breaking news reporter covering US equities for Yahoo Finance. Follow him on X at @byjakeconley or email him at [email protected].</p>