Limited second-round risks reduce need for rate hikes

Fears that the Iran conflict will trigger a sustained resurgence in inflation and a renewed global tightening cycle appear somewhat overdone. Admittedly, inflation in advanced economies looks set to reach 3-4% in the coming months even if the conflict de-escalates quickly. And there are already signs of higher energy costs feeding through to transport and food prices. But the risk of persistent second-round effects seems lower than in 2022-23 given softer labour markets, less fiscal support and the higher starting point for interest rates. While some central banks will tighten policy, the scale of tightening is likely to be more limited than markets anticipate, with many policymakers still inclined to look through a temporary energy-driven rise in inflation. Only in a more adverse scenario – involving prolonged disruption to the Strait of Hormuz and significant infrastructure damage – would we expect a stagflationary dynamic to emerge. In that case, sustained high energy prices and commodity shortages could push inflation back towards recent highs, forcing central banks to raise rates again before weaker growth eventually prompted reversals in 2027.

Note: Jennifer McKeown and Simon MacAdam will be answering questions about the global inflation outlook and central bank responses in an online Drop-In briefing on Tuesday, 2nd June. Register here.