Middle East conflict poses fresh test to central banks as oil shock fuels inflation

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Pedestrians look out across the city skyline as they walk along the Tabiat bridge in Tehran, Iran, on Saturday, Aug. 4, 2018. Ali Mohammadi | Bloomberg | Getty Images

A widening Middle East conflict has posed a fresh test for global central banks, as fears of an oil shock and renewed inflation risks complicate policymakers' calculus for shoring up growth. Crude prices soared on Monday after the U.S. and Israel launched strikes on Iran over the weekend, killing Iranian Supreme Leader Ali Hosseini Khamenei. Tehran responded with missile attacks targeting multiple Gulf countries. Tanker traffic through the Strait of Hormuz, the world's most critical chokepoint for oil shipments, has effectively stalled as the threat of attacks from Iran deterred vessels from passing through the waterway. Brent crude prices extended four days of gains, rising 1.6% to $82.76 a barrel on Wednesday, hovering near the highest level since January 2025. The U.S. West Texas Intermediate crude prices also rose for a third day to $75.48. Higher energy prices would ultimately filter through to consumer and producer prices, particularly for economies that rely heavily on Middle East oil imports, leaving central banks scrambling to reassess their interest rate trajectory. "The ongoing Iran conflict solidifies the case for many central banks to hold rates steady for now," a team of economists at Nomura said in a note on Sunday.

Central banks on alert

As heightened tensions weigh on economic activity, policymakers are juggling a delicate task of balancing inflationary risk against slowing growth. The European Central Bank is caught in what ING economists called a "genuine dilemma," as an oil shock could push already sticky inflation higher while its growth outlook weakens under the strain of higher U.S. tariffs. They added that "to see a rate hike, the eurozone economy would have to show clear resilience." Europe imports nearly all of its oil and a significant share of its liquefied natural gas, raising the risk of a dual energy and trade shock, the bank said. ECB council member Pierre Wunsch said this week officials would avoid reacting hastily to any movements in energy prices. "If it lasts longer, if the increase in energy prices is higher, then we will have to run our models and see what happens," Wunsch said.

Pierre Wunsch, governor of the National Bank of Belgium, during a farewell symposium for former De Nederlandsche Bank NV President Klaas Knot at the central bank headquarters in Amsterdam, Netherlands, on Friday, Oct. 3, 2025. Lina Selg | Bloomberg | Getty Images

Former Treasury Secretary Janet Yellen said the conflict could hit U.S. economic growth and fuel inflationary pressures, holding the Federal Reserve back from cutting rates. "The recent Iran situation puts the Fed even more on hold, more reluctant to cut rates than they were before this happened," Yellen said Monday. U.S. inflation stood at 2.4% in January, above the Fed's 2% target. Yellen warned that President Donald Trump's tariffs could push annual inflation to at least 3%. The latest flare-up comes after Trump's seizure of oil-rich Venezuela earlier this year and his threat to take control of Greenland, another strategically significant energy reserve. Brent crude has risen by 36% so far this year, according to LSEG data, while WTI futures were 32% higher as of Wednesday. The global energy market is grappling with a worst-case scenario, with a prolonged disruption in the Strait potentially pushing Brent oil prices above $100 per barrel and European natural gas prices breaking 60 euros ($70.17) per megawatt hour, according to Bank of America.

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Asia bears the brunt

Asian economies would be particularly exposed. Most crude shipped through the Strait of Hormuz flows to China, India, Japan and South Korea, according to the U.S. Energy Information Administration. Under the assumption of a six-week closure of the Strait of Hormuz and a jump in oil prices from $70 to $85 a barrel, regional inflation in Asia could rise by about 0.7 percentage points, according to Goldman Sachs. The Philippines and Thailand are expected to be the most vulnerable, while China could see a "more modest increase." Sustained oil price hikes may lead Asian central banks such as the Philippines and Indonesia to pause on rate cuts, while policymakers in India and South Korea will likely hold rates steady for longer, said Michael Wan, senior currency analyst at MUFG Bank.

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BMI, a unit of Fitch Solutions, estimates that the conflict will add seven to 27 basis points to headline consumer inflation across Asia, with the sharpest impact in Thailand, South Korea and Singapore due to higher energy weightage in their inflation calculations. "For a 10% oil shock, the inflation addition is small enough that most are likely to look through it. [But] the calculus changes materially at $20–30/per barrel increases, where headline CPI impacts double or triple and second-round effects become harder to ignore," the research firm said. Rate hikes remain largely off the table for now, unless rising oil prices sustain and spill over into food and other commodities from higher transportation and freight costs, seeping into higher core inflation, it said. Nomura expects Malaysia — which it identified as a "relative beneficiary" as a net energy exporter — as well as Australia and Singapore, to tighten interest rates. The bank also lowered its expectations for a rate hike by the Philippine central bank.

"The rise in oil price increases our conviction in Bank Negara Malaysia hiking rates [and] a risk that the Bangko Sentral ng Pilipinas could stay on hold — versus prior baseline of another 25-basis-point cut in April," said Nomura. The bank expects a modest 0.01-percentage-point impact from higher oil prices on Singapore's GDP growth. Indonesia and Singapore both said Monday they are closely monitoring financial markets. Bank Indonesia said it would act to keep the rupiah in line with economic fundamentals, while the Monetary Authority of Singapore said it was assessing the conflict's impact on the domestic economy and financial system.

Fiscal buffers

Fiscal stimulus and subsidies could cushion some of the inflationary impact and relatively benign price pressures heading into 2026, providing a relatively comfortable starting point. "We expect Asia to use fiscal policy as the first line of defense to protect consumers," Nomura economists said. Possible measures include price controls, higher subsidies, fuel excise tax cuts, and lower import tariffs on crude oil and refined products. But subsidies could add fresh strain to governments' already-tight fiscal budget deficits, said Rob Subbaraman, head of global macro research at Nomura on CNBC's "Squawk Box Asia" Tuesday. "So which 'negative' do you want to have: higher inflation or worse fiscal? These are policy choices the governments have to make."