Impact of Israel-Iran on inflation and interest rates

Risks to energy supply are numerous - There are three potential risks to consider from the conflict. First, Iran’s energy supply might be impacted. Iran is a top ten global oil producer, with its production at around 3.5 million barrels per day, or just over 6% of the global total. Its exports are running at roughly 1.5-2 million barrels per day. Second, there are fears that the Strait of Hormuz might be closed or that transportation through it might be disrupted. The Strait is crucial for global energy supplies: roughly 20% of all oil and petroleum products (around 20 million barrels per day) and 20-30% of LNG traded internationally pass through it. Although there are some alternative routes to market via oil pipelines, they would not nearly be enough. The EIA estimates that about 2.6 million b/d of capacity from the Saudi and UAE pipelines could be available to bypass the Strait of Hormuz in the event of a supply disruption. Third, there might be damage to energy infrastructure in other neighbouring oil producing countries in case the conflict spread, though this gets into the realm of the speculative at this stage.

Scenarios for energy prices - In case of disruption to Iran’s oil supplies, some of the impact would likely be ultimately at least partly offset by increasing supply elsewhere, but assuming that a risk premium remains above that, we could see Brent rising towards the $80-90 p/b range. Meanwhile, significant disruption to the Strait of Hormuz could see prices spiking towards $130-140 p/b. Though a complete stop could see more significant spike. Meanwhile, in case of de-escalation, we would likely see the current risk premium quickly dissipate as ultimately it is supply and demand that drives prices, and current conditions, with demand weakening and supply ample, would tend to keep oil prices in check.

Impact on the US & Fed – We estimate inflation could increase by about 0.4-0.5pp in case Brent rises to $90, while a price of $140 would raise inflation by about 1.3pp. The growth impact would likely be limited. Like the rest of the world, the US dependency on oil has significantly decreased and inflation means that $100 oil is not as restrictive as it was a decade ago. In fact, higher oil prices may make Trump’s currently unviable ‘Drill, baby, drill’ plan a viable business case, partly compensating the drag on growth from higher oil prices.

While central banks typically try to see through the inflation impact from oil price changes – they are of course excluded from core inflation measures – this inflationary oil price shock comes on top of the tariff inflation shock, in a context where households are already expecting inflation to rise substantially. An increase in petrol prices would certainly bring an additional impulse to that. Our base case sees the Fed holding rates until the second quarter of 2026, due to higher inflation, a risk of inflation expectations de-anchoring, and a limited downturn in the labour market. An oil price shock would simply increase the amplitude of the path we already foresee, and is therefore unlikely to sway the Fed from this path.

Impact on the eurozone & ECB – The two alternative oil price scenarios we sketch above would impact eurozone inflation by similar magnitudes to the US (see chart below). However, unlike the US, our eurozone base case currently sees a prolonged period of below target inflation, even factoring in the recent rebound in prices (assuming a de-escalation or at least no further escalation from here). The negative growth impact would be somewhat larger than the US, as the eurozone remains a net importer of oil and would not have the same offsetting positive impulse from higher investment in oil extraction. All told, while in the $90 scenario growth would slow to a below trend rate, in the more negative $140 scenario the economy would likely slow sharply by 2026 – close to stagnation. The final impact would also depend on whether governments do anything to offset the impact, such as tax relief. With regards LNG, while disruption to the Strait of Hormuz would likely push natural gas prices higher for a time, the rise in prices we expect to result from this would be well within the bounds of recent history, and its impact on growth and inflation therefore limited.

What does this mean for the ECB? Our base case continues to see the Governing Council having a bit further to go with rate cuts (see here). In the $90 oil scenario, the ECB would likely keep policy on hold from here, while in the more negative $140 scenario we could even see one or two rate hikes as a pre-emptive step to contain inflation expectations. However, any tightening would be limited by a) the growth shock from higher oil prices and b) the low likelihood of significant second round effects, as the aforementioned growth shock should limit worker bargaining power. Even in a worst case scenario, the peak in inflation would be far lower than during the energy crisis (around 3.5% vs 10.6% in October 2022), and we therefore view it as far less likely to trigger significantly higher wage demands that then feed back into prices