Macro Moments Weekly: Inflation in the pipeline

The outbreak of severe hostilities in the skies over and around Iran marks a new chapter in Middle East conflicts. The ferocity of this conflict led to the withdrawal of insurance war premiums, and oil tankers have become stuck on either side of the 37-miles-wide Strait of Hormuz. It is common knowledge that approximately 25% of the world’s seaborn oil passes through this Strait. The largest liquid natural gas refinery, based in Qatar, produces 20% of global liquified natural gas (LNG) products and depends on seaborn passage to export them. As a result, we have seen sharp rises in the price of oil (25%) and natural gas (50%) in the last week. While the current price levels for both are still way below those reached in the first quarter of 2022, it is important to revisit, review and ask, what if the same were to happen now?

Beware the Ides of March

In looking for the answer, I have been lucky enough to participate in and host part of our UK Investment conference last week. Dino Kronfol, Chief Investment Officer of Global Sukuk and MENA Fixed Income at Franklin Templeton, was due to attend the conference in person but was unable to travel from Dubai. Fortunately, we could ‘patch him in’ by teleconference, and he gave a wide-ranging and deeply insightful assessment of the current situation. If the Strait of Hormuz does not re-open to shipping within 12 days (by 15 March, roughly), then oil and gas prices will rise significantly further. Markets at present are not pricing in such a risk.

An old rule of thumb was that a 10% rise in the price of oil will produce a 1% rise in inflation, and this rule worked in 2022. Consumers will see inflation arrive first via energy prices at the petrol (gas) pump, then to businesses—from steel plants to call centres. Then the home bills will rise, such as electricity, gas, the bus and rail fare, and, at the same time, food. These are the items we all feel the most and change our inflationary expectations. As businesses seek to recoup lost profit margins, prices of goods start to rise and, eventually, services. Remember that services may lag a year, as the primary driver of service inflation is wages, and employees, however keen they are to recoup the drop in real income that they experience, only get the chance to do so once a year.

Central banks, armed with their anti-inflation mandates, will likely counter this by raising rates, just as they did in 2022. Here we find, hiding in plain sight, that inflation will likely also rise with rising interest rates, in particular mortgage rates. And, with a lag, rental and insurance costs will also likely increase. This is particularly meaningful in the United States; within the Consumer Price Index (CPI), shelter is 60% of service inflation, and service inflation itself is 60% of the index.¹ Service-sector inflation can be very persistent, and in the United States, shelter inflation has been the principal reason why US CPI has remained relatively high since 2024.

Not only did central banks contribute significantly to inflation after 2022, they also contributed to the sharp rise in government budget deficits, because of the impact of rising interest costs. This increased government borrowing requirements, which then pushed interest rates set in the market up even higher. In some countries, this has led to tax increases. In the United Kingdom, interest costs for government borrowing doubled to 4% of GDP in 2022 and are expected to cost £111 billion in 2025-26.²  

In response to another energy-price crisis, the key question for the markets is the reaction of the central banks, as they must counter the upward inflation impact of energy prices. Markets need to decide how much rates should rise to ensure that the secondary effects of inflation do not take hold, so that central banks can fulfil their mandates.

The answer to that question is very different today from that of 2022. Then, we started with interest rates that were zero, or close to it. With short-term rates today at 2% in Europe and at 3.75% in the United States and United Kingdom, the increase needed to return monetary policy to a restrictive and thus anti-inflationary level is not much, perhaps only 100 basis points in each case.

However, a rate change of this size would be a shock to financial markets, which have been expecting two more rate cuts from the US Federal Open Market Committee and from the United Kingdom’s Monetary Policy Committee during 2026. But because of where we start with current rates, the impact of a much smaller increase would likely be greater and more effective than in 2022. As a result, central banks should be able to cut rates faster once the initial inflationary shock has passed.

The downside to this scenario is that we are likely to see lower economic growth at a time when it is already in short supply in our region. Europe and the United Kingdom, as major energy importers, are the most vulnerable to such a shock. In the United States, a rate increase may be unnecessary, given that the economy is self-sufficient in oil, and current rates are already tight. Rates may just stay higher for longer. But an early, sharp rise might even drive down longer bond yields due to rising investor confidence and that would, in the long term, cut government debt costs.

For equity markets, growth and earnings forecasts would be hit, and valuations would need to reflect both this and the disappointment of moving so swiftly from an easing to a tightening regime. There could be a rise in credit defaults, an area of concern to many already. But if there were a recession, I think it would likely be short and shallow, and this would raise the prospect of interest rates falling again in 2027, perhaps well below where we are today. That prospect could limit the size of the negative equity market reaction.

These conditions are not all in place yet: We do not know how long the war in the Persian Gulf will last or its impact on oil, let alone the final outcome. But if it lasts more than a few weeks, markets will need to price in inflation fears and rate rises.

When I first went to New York in the mid-1990s, I had instructions to tip the hotel doorman: ‘Tip hard and tip early,’ was the advice from my Chief Investment Officer. I would suggest the same advice for the Federal Reserve, the European Central Bank and the Bank of England today.

Parting shot

On 6 March 1930, Clarence Birdseye launched his new frozen food range in 18 shops in Springfield, Massachusetts. In 1955 he introduced the fish finger, but Captain Birdseye, the mascot, didn’t appear until 1967. Good product needs good marketing, but that can take time.