Before the war started, I mentioned that a US-Iran conflict would likely have disastrous effects on the markets and the global economy due to stagflation risks. The reason is simple: severe oil supply disruptions raise costs across the economy, reduce consumer spending and business investment, create inflation, and slow economic growth.
Central banks cannot fix the root problem (shortage of oil) but they can use monetary policy to either support the economy or slow inflation. The problem is that they are cornered right now. If they cut rates to support the economy, it could lead to more serious problems with inflation in the future, especially after five years of above target inflation.
If they hike rates, they could exacerbate the negative impact on the economy and trigger a recession. If they do nothing and let the economy weaken hoping for the event to be “transitory”, we could still end up in a recession.
The market has recently pared back rate cut bets for most major central banks, but traders have also priced in high chances of rate hikes, which just looks overblown. If central banks hike rates because of this negative supply shock, a recession would be almost guaranteed as stock markets would fall hard and economic activity would slow enough to tip the labour markets over.
Unfortunately, they can’t even cut until the shock is over because after five years of above target inflation, the risk is that they trigger another inflationary spiral.
The only thing they can do is to wait and hope it ends quickly, which is not a good strategy but it’s the only one they have right now…
