Gulf turmoil will leave ratesetters on edge

Gulf in expectations. Central bankers are probably watching unfolding events in the Middle East through their fingers. Tuesday’s strike by Iran on Israel raises the risk of a robust riposte. One of the dangers facing the global economy is that the conflict makes a mess of ratesetters’ plans to loosen monetary policy.

Tehran’s 180-missile attack makes it more likely that Israel responds with a direct strike on a meaningful piece of Iranian infrastructure. One potential target is the Islamic Republic’s Kharg Island facility, which handles around 90% of its oil exports. If that then caused Iran to restrict access to the Strait of Hormuz, through which a fifth of daily oil supply passes, crude prices could spike above $100 a barrel, like they did in 2022 after Russia’s invasion of Ukraine.

U.S. Federal Reserve and European Central Bank ratesetters have plenty of reasons not to panic. Given Iran’s missiles caused minimal casualties as Israeli defence systems aided by allies like the U.S. shot them down, Israel may restrict any response to Iran-backed Hezbollah in Lebanon. Even if it doesn’t, oil swing producer Saudi Arabia’s potential to pump a lot more crude may offset all but the most serious of Gulf export blockages – its oil minister even warned fellow members of the Organization of the Petroleum Exporting Countries that prices could slump to just $50 a barrel if they failed to observe agreed cuts.

Still, central bankers aren’t very good at managing energy supply shocks – U.S. and European inflation soared to high-single-digit levels amid the 2022 power crisis. A serious Middle East-derived repeat, along with other inflationary headaches like the U.S. longshoremen strike, could leave Fed chief Jay Powell and his ECB counterpart Christine Lagarde with a dilemma. Continuing to reduce rates would almost certainly fuel bigger price increases. But pausing rate cuts, or even raising borrowing costs again, would sharply increase the risk of recession for an already sluggish global economy.

Right now, investors aren’t factoring much of this in. In Europe, weak economic data means traders expect a second consecutive rate cut to 3.25% on Oct. 17, according to derivative prices collected by LSEG. They also anticipate a steady stream of reductions after that, leaving the deposit rate at 1.75% by October next year. U.S. derivative prices, meanwhile, imply that the benchmark rate will fall to around 3% by October 2025 from around 4.9% now.

Powell and Co are still some way from having to contemplate a major volte-face. But having missed an inflationary spike within the last five years, they are likely to respond even more quickly if events in the Middle East intensify.

Context News

Israeli Prime Minister Benjamin Netanyahu promised that arch foe Iran would pay for its missile attack against Israel on Oct. 1, while Tehran said any retaliation would be met with “vast destruction”, raising fears of a wider war. As the United States expressed full backing for its longtime ally Israel, Iran’s armed forces said direct intervention by Israel’s supporters against Tehran would provoke a “strong attack” from Iran on their “bases and interests” in the region. Oil prices rose 5% on fears of a wider war. As of 0828 GMT Brent was trading at $75.3 a barrel, up 2.1%. In its attack on Tuesday, Iran fired more than 180 ballistic missiles at Israel, Israel said. Alarms sounded across Israel and explosions could be heard in Jerusalem and the Jordan River valley. Israelis piled into bomb shelters and reporters on state television lay flat on the ground during live broadcasts. U.S. Navy warships fired about a dozen interceptors against Iranian missiles headed toward Israel, the Pentagon said. U.S. President Joe Biden expressed full U.S. support for Israel and described Iran’s attack as “ineffective”. He said there was an active discussion about how Israel would respond, and he would confer with Netanyahu.