Middle East conflict: Central bank forecast changes

Tensions between the U.S. and Iran have escalated sharply, marked by military exchanges and increasingly confrontational rhetoric. Attacks on key Middle Eastern energy infrastructure have heightened the risk of material supply disruptions, amplifying uncertainty across global markets. While there are tentative signs of de‑escalation—including reports that President Trump has ordered a five‑day pause on planned strikes against Iranian power and energy facilities—the situation remains highly fluid, with risks of retaliation and broader supply‑chain disruption still elevated.

The escalation has triggered a sell off in global equities, most acute in Asia, where economies are highly exposed to Middle Eastern energy supply. European equities have also fallen meaningfully as investors reassess growth and inflation risks. U.S. equities, while weaker, have been comparatively more resilient.

The most pronounced reaction has been in bond markets. Following recent central bank meetings, markets have moved decisively to price a more hawkish global policy response, with yields rising sharply as investors reassess the risk that energy driven inflation proves persistent enough to warrant tighter policy.

If the shock endures, central banks face increasingly difficult trade offs. Prolonged energy price pressures sharpen the inflation–growth dilemma, as restoring inflation to target would require a more restrictive stance at a higher cost to growth and employment. In the U.S., higher energy investment may partially offset the drag, but near term pressure on real incomes is likely to dominate.

History suggests U.S. equities tend to struggle most during geopolitical crises when the Federal Reserve tightens policy despite deteriorating financial conditions. In such episodes, policy tightening has typically weighed more heavily on returns than the geopolitical shock itself.

Since the oil shocks of the 1970s and 1980s, the Fed has generally avoided tightening in response to supply‑driven inflation, aided by inflation targeting and improved central bank credibility. The key exception was 2022, when central banks tightened aggressively following Russia’s invasion of Ukraine, though inflation pressures were already elevated due to post‑pandemic supply constraints and expansive fiscal policy.

That episode matters. Central banks were widely criticized for responding too late, and with inflation remaining above target for several years in many economies, the threshold for responding to a sustained energy price shock has likely been lowered.

At the onset of the conflict, we outlined three scenarios for higher energy prices:

Baseline: A brief oil spike with negligible growth effects and a temporary ~0.2ppt lift to headline inflation, with little policy impact. 

Medium adverse: Oil stabilizes around $90/bbl for several months, modestly slowing growth and pushing core inflation toward 3%—constraining rate cuts. 

Severe adverse (tail risk): A multi‑quarter disruption, potentially including a closure of the Strait of Hormuz, drives Brent oil above $125/bbl, materially weakens growth, lifts core inflation above 3.5%—raising the odds of policy tightening. 

Recent developments move us out of the baseline and toward a point between the medium and severe adverse scenarios. Brent oil prices are now likely to stabilize in a $90–$115/bbl range for several months, with widening supply‑chain risks as damage to Gulf energy infrastructure accumulates. As a result, we’ve made revisions to our Fed, ECB, and BoE policy projections. 

At the start of the year, markets expected rate cuts from the Fed, ECB, and BoE. In recent weeks, pricing has swung sharply toward hikes across all three—a dramatic repricing. Our own starting point for 2026 had been two Fed cuts in H2, no ECB cuts, and two BoE cuts.

Last week, major central banks held rates steady but emphasised upside inflation risks alongside concerns about demand destruction. While the tone was broadly hawkish, urgency differed: the Fed was least hawkish, the Bank of England most.

Original forecast: Two cuts (June and September)

Revised view: Cuts delayed

The Fed’s dual mandate implies sensitivity to both inflation risks and demand destruction. We expect the FOMC to largely look through the rise in headline inflation and, unlike markets, we do not anticipate rate hikes this year. Labor market softening and affordability pressures argue for an eventual return toward neutral.

However, with inflation having remained above target for five years and now facing upside risks from both tariffs and energy prices, the Fed is likely to proceed cautiously and will require clear and sustained evidence that core inflation has moderated and inflation expectations remain anchored. As Chair Powell noted, without visible progress on inflation, cuts are off the table. June now looks too soon. The first cut is more likely in September, if not December, with a second 25bps cut pushed into early 2027.

Original forecast: Policy on hold through 2026

Revised view: One or two hikes in 2026

With a single mandate focused on price stability, the ECB has less flexibility to tolerate upside inflation risks. Inflation is likely to rise above 3% and remain elevated through year‑end. 

We now expect one or two rate hikes this year, still fewer than markets price, pushing policy toward the upper end of neutral. While the Governing Council has left the door open to act quickly, we expect the first hike in June rather than as early as April. 

While weaker growth may not prevent short‑term tightening by the ECB or BoE, we doubt central banks will tighten aggressively or for long. Economic deterioration is likely to reassert itself, with all three central banks resuming rate cuts in 2027 as policy returns toward neutral.

The Middle East conflict is proving more prolonged and economically disruptive than markets initially assumed. Bond markets have reacted more forcefully than equities as investors reassess inflation persistence and central bank responses. While policymakers are clearly shifting hawkishly, we believe markets are pricing an overly aggressive path for rates.

Forecast uncertainty is unusually high. While a short‑lived resolution remains possible, a prolonged conflict with sustained energy price pressure would likely elicit a firmer policy response. Investors should expect volatility, remain nimble, and stay diversified.