A pivotal week for global monetary policy is underway, with several of the world's most influential central banks set to announce their latest decisions. The Bank of Japan, Bank of Canada, Federal Reserve, Bank of England, and European Central Bank are all expected to hold interest rates steady — but the calm on the surface masks a deeply uncomfortable set of choices building beneath it.
The Middle East conflict, now nine weeks old, remains the dominant backdrop. Despite ongoing talk of diplomatic progress, the Strait of Hormuz remains closed, and physical oil prices are holding at elevated levels. While the figures displayed on trading screens may appear less alarming, the prices being paid for physical barrels — and what consumers are seeing at the fuel pump — tell a very different story.
It is that consumer-facing reality that is fast becoming a central concern for monetary policymakers around the world. If the current situation persists and higher energy costs become more deeply embedded across other sectors of the economy, central banks will face intensifying pressure to act.
The core problem is that monetary policy is poorly suited to addressing a supply shock or a negative demand shock — and that is precisely the nature of the current disruption. Surging oil and gas prices are feeding through to inflation via cost-push factors, a dynamic that central banks find particularly difficult to manage. Yet despite this, some policymakers appear to feel compelled to respond, driven by their mandate to anchor inflation expectations and maintain credibility.
The difficulty is that raising interest rates will do nothing to reopen the Strait of Hormuz, end the war in the Middle East, or restore disrupted energy infrastructure in the Gulf region. What it will do is further compress demand at a time when households and businesses are already under severe strain — raising the risk of economic stagnation or outright recession, particularly if the conflict drags on for additional weeks or months. The financial toll on consumers and businesses grows exponentially with each passing week.
If policymakers move too quickly, they risk triggering stagflationary pressures — a scenario that would represent a serious setback after the careful work done to bring inflation under control in the aftermath of the Russia-Ukraine conflict in 2021 and 2022.
The second dimension of the problem is the communication challenge central banks have already created for themselves. Even without explicit commitments, the shift away from a rate-cutting path toward opening the door to further hikes has sent a strong signal to markets. Investors have responded by pricing in a handful of additional rate increases before year-end.
The danger now is a credibility trap. If policymakers conclude that rate hikes cannot solve an energy shock and choose not to follow through, markets — which have already done significant tightening work by pricing in those hikes — will loosen financial conditions. That reversal could allow inflation to accelerate, especially if second-round effects begin to take hold. That particular risk is one central banks fear deeply, even in a scenario where the Middle East conflict were to end immediately.
The question then becomes: how much would rates need to rise to contain those second-round effects? Consider the European Central Bank as an illustration. The ECB entered this year having already cut its deposit facility rate to 2.00%, with policymakers estimating the neutral rate range at roughly 1.75% to 2.25%. Two additional 25 basis point hikes would bring the rate to 2.50% — barely above neutral and only marginally restrictive. Whether that would be sufficient to bring inflation back down, especially in the face of second-round risks, is far from clear.
A token rate increase followed by a pivot back to cuts next year would likely be viewed as a poor trade-off given the risks involved. The optics alone present a problem, let alone the underlying economics.
Central banks are therefore caught in a genuine bind — acting too early risks compounding an already fragile economic situation, while acting too late risks allowing inflation to become entrenched. Either path carries the potential to tip the economy into a recession spiral or an inflationary one. Striking the right balance is an exceptionally difficult task.
For this week at least, holding rates steady appears to be the appropriate course. But as the conflict extends and inflation pressures continue to build, the window for staying on the sidelines is narrowing. The longer policymakers wait, the harder the eventual decision becomes.
Why it matters
Cost-push inflation — driven by energy supply disruptions rather than excess demand — is structurally resistant to interest rate increases, meaning rate hikes risk slowing growth without meaningfully reducing the underlying price pressure.
The ECB example in the article illustrates a specific constraint: even two additional 25 basis point hikes would leave its deposit rate only marginally above the estimated neutral range, raising genuine doubt about whether such moves would be sufficient to contain second-round inflation effects.
Markets have already priced in further rate increases based on central bank signalling; if policymakers reverse course without acting, the resulting loosening of financial conditions could itself become an inflation accelerant — independent of whether the conflict continues.
