Alert Sounded! Iran Conflict Triggers Inflation Concerns, Is the Global Rate-Cutting Wave About to Fizzle Out?

Faced with the potential resurgence of inflation threats, from the Federal Reserve to the European Central Bank, central bank leaders worldwide are confronting a tricky dilemma: can their scheduled rate cuts still proceed on time?

Major central banks around the world are gathering this week. In light of a new wave of inflation threats stemming from the Iran conflict, they may be forced to delay rate cuts, and in some cases, even consider raising interest rates.

However, a major policy shift is not imminent: the Fed, ECB, and Bank of England are expected to keep borrowing costs unchanged, as they need time to carefully assess how soaring energy prices will impact consumer prices and economic growth.

But for them and the other 18 central banks (which oversee about two-thirds of the global economy) that are about to set policy, the tone will become more cautious after recognizing the risk of yet another inflation shock.

The direction of the situation largely depends on how long the conflict lasts, which is currently unpredictable for markets. With oil prices fluctuating wildly and U.S. President Trump’s next moves uncertain, investors wary of stagflation risks are already confused. This raises the question: how quickly can central bank leaders respond to new price pressures?

What’s certain is that global policymakers (who are also weighing the costs of U.S. tariffs and trying to cope with an increasingly divided geopolitical landscape) are reluctantly preparing: if the Middle East situation reignites inflation, hampers economic growth, or threatens their currencies, they will have to intervene again.

“Central banks can set interest rates, but they cannot reopen the Strait of Hormuz,” said Tom Orlik, Chief Economist at Bloomberg Economics. “We expect Powell, Lagarde, and Bailey to hold steady, sending cautious signals, and silently praying that the Iran conflict ends soon to avoid another uncontrollable inflation problem.”

It’s not just Iran that has everyone on high alert. The painful memories of the last inflation shock are still fresh—after the Russia-Ukraine conflict erupted in 2022, some major economies saw inflation rates spike into double digits.

Like last time, it’s hard to estimate how long the fighting will last.

Trump’s stance has been inconsistent: sometimes saying the conflict might end “soon,” other times claiming the U.S. has “plenty of time” while bombing targets from the air. Meanwhile, Iran’s new Supreme Leader, Ayatollah Khamenei, has vowed to keep the Strait of Hormuz—key energy transit route—substantially closed.

For now, the U.S. labor market’s cracks have masked the inflation risks from the Middle East situation, so lowering borrowing costs remains on the Fed’s radar, though no action is expected this month.

While markets are no longer fully pricing in rate cuts by 2026, the overall bias remains toward easing, making the U.S. somewhat of an outlier among the G7.

In fact, with public dissatisfaction over rising gasoline prices ahead of midterm elections, Trump has again called for rate cuts and even suggested temporary easing measures.

Morgan Stanley economists remain firm in their forecast that the Fed will cut rates by 25 basis points in June and September. They note that rate cuts might be delayed, but that could lead to more aggressive action later.

Christoph Balz, an economist at Deutsche Bank, said that even if oil prices stay high for a longer period, “considering the political pressure to maintain loose monetary policy—especially before the November elections—the likelihood of rate cuts remains higher than that of hikes.”

Europe

In Europe, the situation is quite different. Despite economic growth facing risks, the focus is firmly on fighting inflation, and market expectations for further easing have largely vanished.

In the UK, where inflation briefly exceeded 11% in 2022, just before the US and Israel attacked Iran, the probability of a rate cut in March was nearly 80%. Now, policymakers are expected to hold steady. Although some economists, including Goldman Sachs, still forecast rate cuts later this year, traders are already betting on hikes.

Emma Moriarty, Portfolio Manager at CG Asset Management, believes that the Bank of England is facing a “classic stagflation dilemma.” “On one hand, the BOE needs to show a proactive stance to anchor inflation expectations,” she said in an interview with Bloomberg TV last Friday. “On the other hand, raising rates risks further weakening demand.”

By contrast, the Eurozone, with 21 member countries, has a slightly more resilient economy, and its situation in tackling inflation is better than last time. Officials are expected to keep borrowing costs unchanged this Thursday, though some hint at future action.

Fabio Balboni, senior economist at HSBC, said that the lessons from 2022 “may make the ECB more cautious about expectations spiraling out of control; if energy prices remain under pressure, they might hike faster.”

Markets strongly believe the ECB will have to act, betting on one or two rate hikes this year. However, a Bloomberg survey of analysts shows only 7% expect tightening measures.

Japan

In Japan, the likelihood of rate hikes is higher, as inflation has exceeded the Bank of Japan’s 2% target for four consecutive years. Sources say that after holding steady this Thursday, a rate increase in April is not out of the question.

Like much of Asia, Japan relies heavily on Middle Eastern oil imports—over 80% of its eastward oil shipments pass through the Strait of Hormuz. This means sustained high oil prices could weigh heavily on Japan’s inflation and economic growth.

According to Bloomberg economists Bhargavi Sakthivel and Ziad Daoud’s models, a one-month blockade could push Brent crude to $105 per barrel; a three-month blockade could see prices approaching $164.

Carsten Klude, chief economist at M.M. Warburg & Co., said: “The Strait of Hormuz will determine how things develop. It’s a real bottleneck. Ignoring it would be ignoring the most critical transmission channel of this crisis.”

Beyond these major economies, some other central banks may take small immediate rate actions. Economists expect that the spillover effects of the Iran situation will prompt Australia to move its planned May rate hike to this Tuesday, continuing the tightening cycle started in February.

Thierry Wizman, Global FX and Rates Strategist at Macquarie Group, said: “As long as inflation threats from the war persist, central banks will stay hawkish. We expect that even after hostilities end, this ‘hawkish’ tendency will continue.”

In other regions, Brazil is likely to announce a rate cut this Wednesday, due to sluggish economic growth late last year and borrowing costs near 20-year highs. Still, easing policies are expected to proceed gradually. After an official mentioned that the central bank “cannot ignore” the war’s consequences, market opinions on the size of this week’s cut diverge.

These examples highlight how the Iran conflict impacts economies at different stages of the cycle, requiring varied policy responses, which will significantly influence forex markets.

Safe-haven flows have already pushed up the dollar and Swiss franc, with the latter facing upward pressure that could lead the Swiss National Bank to adopt a more hawkish tone in currency interventions.

Japanese officials face the opposite challenge: acknowledging economic risks could further weaken the yen. The yen-dollar exchange rate hovers around 160, a level that previously triggered official intervention in 2024.

Exchange rate issues are also a major concern for Indonesia. While fuel subsidies might cushion inflation spikes, fiscal worries could lead to deficits widening, risking capital outflows and undermining the central bank’s efforts to maintain currency stability.

Given the series of challenges sparked by this conflict, policymakers across continents will tailor their “prescriptions” differently. The International Monetary Fund (IMF) emphasizes that, with the timing of the conflict’s end still uncertain, flexibility remains key. IMF Chief Kristalina Georgieva stated:

“If this new conflict proves to be prolonged, it will likely impact market sentiment, economic growth, and inflation, posing new challenges for policymakers. In this new global landscape, we must consider seemingly unlikely scenarios and prepare in advance.”