Central bank governors around the world are waking up to their worst nightmare: an oil price shock that simultaneously drives up inflation and forces them to abandon the interest rate cuts they had been planning to support slowing economies. The Iran conflict’s more than 25% weekly surge in Brent crude oil — to above $91 a barrel — has created exactly the toxic combination of rising prices and faltering growth that monetary policy is least equipped to handle.
The problem for central banks is that oil price shocks are supply-side events, not demand-side ones. The standard monetary policy response to inflation is to raise interest rates, reducing demand and cooling prices. But when prices are rising because of a supply disruption rather than excessive demand, raising interest rates reduces economic activity without addressing the underlying cause of the inflation — and cutting rates, which would support growth, risks entrenching the inflationary shock.
In the UK, this dilemma has played out with extraordinary speed. The probability of a Bank of England rate cut this month fell from 80% to just 15% in the space of days. UK bond yields recorded their biggest weekly jump since the Liz Truss mini-budget crisis. The Bank faces a choice between supporting an economy suffering from an energy supply shock and maintaining its credibility on inflation — and the latter appears to have won, for now.
The European Central Bank faces the same dilemma. Money markets have shifted from pricing in rate cuts to pricing in a possible rate rise by year’s end. Eurozone bond yields recorded their biggest weekly jump since March of the previous year. For an economy that had been cautiously emerging from its post-pandemic inflation episode, the prospect of another energy-driven inflationary surge is deeply unwelcome.
The drivers of the central banking nightmare show no signs of abating. Kuwait has cut production, Saudi Arabia and UAE face storage exhaustion within 20 days, Qatar’s LNG exports are disrupted, and Qatar’s energy minister has warned of oil at $150 if all Gulf exporters halt production. For central banks trying to navigate between inflation and recession, the Iran conflict has moved the goalposts in the most challenging possible direction.