Inflation and rate-hike outlook of the US-Iran conflict

Today's macro backdrop differs from 2022/23; central banks unlikely to kickstart rate-hike cycle
Previously, global output disruption left no alternatives; lax monetary policy, economic overheating sparked secondround inflation
Today, only one region's energy supply is affected; no second-round inflation despite high energy prices

The US-Iran conflict remains unresolved, driving inflation expectations upward. Markets fear that central banks may kickstart a rate-hike cycle similar to that of 2022-2023. However, today's inflationary environment bears little resemblance to that period. For now, the likelihood of central banks restarting a rate-hike cycle remains low.

The previous rate-hike cycle was triggered by global supply-chain disruptions and demand shocks prompted by the pandemic. At that time, worldwide industrial supply chains were upended; while Country A faced acute shortages, other nations were unable to fill the gap because they, too, had suspended production. Even when goods were manufactured, they frequently encountered bottlenecks at global ports and in shipping deliveries. In that environment, alternatives were difficult to come by regardless of a buyer's willingness to pay a premium. Furthermore, the disruption was global, not limited to one region. In contrast, although the Middle East crisis today has resulted in a blockade of the Strait of Hormuz, disrupting seaborne energy shipments, it has not brought global production capacity to a standstill. Buyers can still source energy from alternative markets, albeit at higher prices.

In the post-pandemic era, the gradual return to normalcy released significant pent-up demand. Governments maintained accommodative monetary policies, propping up economies with ultra-low interest rates. This led to economic overheating, triggering second-round effects on inflation. The 2022 outbreak of the Russia-Ukraine war disrupted energy supplies, including LNG, further exacerbating inflationary pressures. By June 2022, the US CPI reached a high of 9.1%. To combat inflation, the Fed hiked rates 11 times, bringing the federal funds rate to a 22-year high of 5.25-5.5%, while Europe raised its rate from -0.5% to 4%.

This time, the Middle East crisis has not triggered a surge in consumer demand, nor has it put the economy at risk of overheating. Prior to the conflict, inflation was on a steady downward trajectory across markets, including Europe and the US. While US inflation saw a rebound in March following the outbreak of the war, this uptrend is expected to be transitory. Although the situation remains fragile, both the US and Iran are believed to have little incentive to further escalate military actions. Given that the US is only six months away from the midterm elections, elevated gas prices and resurgent inflation are politically detrimental to Republicans. Meanwhile, Iran cannot afford to forfeit its oil revenues for long. As such, the situation is likely to ease, eventually driving energy prices lower.

The previous rate-hike cycle aimed to reverse the accommodative monetary policy of the time and tame overheating demand. Today, interest rates across markets, including Europe and the US, are generally at a neutral level, neither expansionary nor growth-supporting. While monetary policy cannot directly counter a supply shock, raising rates at this stage could stifle economic growth and the labour market. At present, central banks are focused on striking a balance between rising inflation and the risk of a softening job market. In the face of a murky inflation outlook, central banks in the US, Japan, Canada and the UK held rates steady following their April meetings. Conditions for a rate hike will be considered ripe only if long-term inflation expectations persist while wage growth remains robust.

Although the Middle East conflict is driving up inflation, the broader market backdrop differs significantly from the pandemic era. Raising rates prematurely could spark unwanted economic volatility. Since soaring energy prices have yet to produce second-round effects on inflation, it is unlikely for the time being that central banks will commence a new rate-hike cycle. Given the current landscape, a diversified portfolio of equities and bonds could help investors manage risk and ride out market volatility.