Middle East Tensions Reshape Inflation Expectations, Are Rate Hike Options Back on Major Central Banks' Table

After more than two weeks of ongoing turmoil in the Middle East, major economies from Washington and London to Frankfurt will intensively announce interest rate decisions over the next week.

Driven by geopolitical risk premiums, as of March 15, Brent crude oil prices have risen to $103.86 per barrel, and WTI crude oil prices have reached $98.71 per barrel, representing a 36% and 38.6% increase respectively since early March.

How will this new round of inflationary shocks from rising prices reshape the global inflation trajectory in 2026? Is the so-called “inflation rebound” merely short-term volatility, or does it signal long-term structural risks?

Regarding these questions, Cameron Systermans, Head of Multi-Asset at Mercer Asia Pacific, told Yicai that unless the shock is large enough and lasts long enough to produce a second-round inflation effect, the rise in energy and transportation costs alone is unlikely to substantially disrupt the current rate-cutting pace of the Federal Reserve and the European Central Bank.

“Our baseline forecast remains that the Fed will continue to cut rates this year, and we believe the ECB has completed its easing cycle,” he said.

2026 Global Inflation Trajectory

Systermans stated that the main channels influencing the 2026 inflation path will focus on oil prices and supply chain transportation costs. He emphasized that the extent of inflation damage depends on the severity and duration of the oil supply shock, especially whether the Strait of Hormuz, which accounts for about 20% of global seaborne oil, faces prolonged disruption.

He cited a Fed study indicating that if the shock is large and persistent, overall inflation could rise. “A 10% increase in oil prices could add approximately 40 basis points to U.S. overall inflation over several quarters, with peak contributions of about 15 basis points to core inflation.” Additionally, shipping insurance rates through the Persian Gulf could surge by up to 50%, making this supply chain cost transmission a “key risk.”

However, Systermans currently tends to categorize such risks as short-term or conditional volatility. He believes that as long as shipping volumes through the Strait of Hormuz recover quickly and there is no significant infrastructure damage, oil prices are expected to decline.

Notably, the International Energy Agency (IEA) recently released a record 400 million barrels of crude oil from reserves. Lorenzo Codogno, former chief economist of Italy’s Ministry of Economy and Finance and visiting professor at the London School of Economics’ European Institute, said this is enough to offset about 20 days of supply disruption in the strait and to some extent serve as a price stabilizer.

However, compared to the oil market supported by strategic reserves, Europe’s natural gas market faces greater impact. According to the Swiss Federal Office of Energy, EU gas storage levels are below 30% of full capacity. Reports indicate that the European Commission will introduce new regulations by March 18, instructing member states to maintain flexibility in implementing EU gas import rules.

Codogno told Yicai that if energy prices (not just oil but also natural gas) spike for only a few weeks, there may be no need to adjust monetary policy. But if the conflict persists and keeps prices high long-term, the risk of a second-round effect could trigger rate adjustments.

Specifically, he outlined two possible scenarios for inflation evolution in 2026. In the high-probability (80%) baseline scenario, he expects the conflict to cease within a month. Under this scenario, although energy prices in the eurozone’s consumption basket could rise sharply by 25% to 35% in the first half of 2026, and March inflation could increase by 1.2 to 2.0 percentage points, this shock would gradually be absorbed after summer.

He warned that while the eurozone’s ability to respond to energy shocks has improved since 2022, policy uncertainties mean energy prices are unlikely to return to pre-crisis levels in the short term. In the 20% extreme deterioration scenario, if the conflict drags on causing energy shortages and production cuts, oil prices could surge to $150 per barrel, with inflation soaring above 10%, and the second-round effects could fully impact wages and all non-energy goods.

Central Bank Actions at Critical Moments

In the midst of inflation uncertainty, markets are closely watching the actual actions of central banks.

Next Tuesday (March 17), the Reserve Bank of Australia (RBA) will announce its interest rate decision. Since October 2022, Australia’s unemployment rate has fluctuated between 3.4% and 4.4%. The RBA has previously adopted a “soft landing” strategy, but Governor Michele Bullock recently stated that while supply shocks like oil price spikes are usually easier for central banks to interpret, persistent inflation would make such operations more difficult. The bank is prepared to seriously consider rate hikes.

Following that, on March 18, the Federal Reserve’s Federal Open Market Committee (FOMC) will release its rate statement and latest quarterly economic projections (dot plot). The market consensus currently leans toward the Fed holding rates steady. On the same day, the Bank of Canada will also announce its decision, with expectations that Governor Tiff Macklem will maintain the benchmark rate at 2.25%.

On March 19, the Bank of Japan, European Central Bank, Bank of England, Swiss National Bank, and Riksbank will sequentially release their decisions. ECB President Christine Lagarde previously stated, “The level of uncertainty and volatility is absolutely shocking, unprecedented in 2022,” and she believes this makes “managing the situation extremely difficult,” so “hasty decisions are unlikely.”

Systermans believes that unless inflation expectations spiral out of control or there are lagging second-round effects like wage increases, major central banks are more inclined to “see through” the temporary inflation driven by oil prices.

Jie Hu, a former senior economist at the Federal Reserve and professor at Shanghai Jiao Tong University’s Shanghai Advanced Institute of Finance, also told Yicai that whether it’s the Fed or the ECB, their monetary policy core logic remains anchored in balancing inflation and employment. He observed that while the real economic impacts have not fully materialized, market expectations have already diverged and are reflected in asset prices in real time. Hu believes that the current turbulence shows market pessimism but has not yet spiraled out of control. The key variable moving forward is the market’s outlook on oil and natural gas supply prospects. “This is largely beyond pure economic considerations,” he added.

(This article is from Yicai.)