Oil shock complicates central bank outlooks

Key points

• Oil prices above $100 are pushing inflation higher while slowing growth, leaving central banks grappling with a stagflationary backdrop that pressures both equities and bonds.

• The ECB and BoE are more exposed to energy‑driven inflation risks and are now leaning towards higher‑for‑longer rates.

• While central banks may look through the initial shock, concerns about inflation becoming embedded via wages and expectations mean that they are likely to err on the side of caution.

The Middle East conflict has thrust global central banks into uncomfortable territory. With oil prices having risen above $100 per barrel since the start of the conflict and expected to remain elevated in the weeks ahead, central banks face a challenge: how to respond when inflation accelerates and growth slows simultaneously.

This is a classic stagflationary shock. Oil price increases hit consumers and businesses almost immediately. Drivers feel it at the pump, the cost of transporting goods rises and price pressures start to ripple through the economy. Households and companies forced to pay more for energy have less to spend and invest, dragging down demand and pressuring economic growth.

Central banks find themselves pulled in opposite directions. Higher inflation implies tightening, but slowing growth implies easing. This high inflation/low growth combination could weigh on both equity and bond prices.

The calculus of forthcoming policy decisions

The US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) explicitly addressed the energy shock in their April policy statements.

The ECB, given its reliance on energy imports, is particularly sensitive to the shock. Although it isn’t our baseline case, this sensitivity could lead the ECB to reverse a rate-cut cycle that took the deposit facility rate from 4% to 2% between June 2024 and June 2025. We have already revised our policy outlook for the UK and now expect the BoE to maintain the bank rate at 3.75%, not make two quarter-point cuts in 2026 as we had anticipated before the conflict.

How our central bank forecasts have shifted

Notes: Forecasts are for monetary policy rates at year-end 2026. The Fed’s forecast reflects the rounded midpoint of the Fed’s target policy-rate range.

Source: Vanguard.

We assess US monetary policy to be near neutral, where the policy rate would neither stimulate nor restrict economic activity. Although we continue to expect one quarter-point rate cut in 2026 from the current 3.5%–3.75% range, risks have shifted towards a longer period of policy inertia while the conflict plays out.

The effect of suddenly rising energy prices and monetary policy lags

The fundamental challenge is timing. While energy prices can surge overnight, monetary policy works with a lag. By the time higher interest rates soften demand - and, by extension, price increases - inflationary pressures may have already taken hold. The conventional wisdom has been to “look through” such supply shocks. But central banks can’t ignore potential knock-on effects. If higher inflation leads workers to demand higher wages, which feeds into broader price pressures, a temporary shock could become persistent. This is why we expect central banks to err on the side of caution in containing inflation.

The path depends on each central bank’s starting point. With inflation having tracked close to its 2% target in recent months and the labour market stable, the ECB finds itself in a stronger position to deal with an inflationary shock than in February 2022, when inflation was already at 6% and the labour market was tight. That recent history could keep the course of policy finely balanced between hiking and holding, with memories of surging inflation still fresh.

Assuming oil prices in a $90–$100 per barrel range and natural gas averaging €60/megawatt-hour for one to two quarters, we upgraded our 2026 ECB headline inflation forecast to 2.5% while lifting our forecast for core inflation - which excludes volatile food and energy prices - more modestly to 2.1%.

The BoE finds itself in more precarious territory. UK inflation has been above its 2% target for roughly five years. Core inflation remained above 3% in March 2026. Policymakers are still fighting the last battle even as a new one arrives. We recently downgraded our 2026 UK GDP forecast by 0.4 percentage points to 0.6%.

The US central bank has greater flexibility. As a net oil exporter, the US is experiencing a smaller shock overall. Higher oil prices hurt consumers but benefit domestic producers. While sticky services inflation and tariff pass-through create complications, the Fed can be patient. The dominant risk is that rates stay higher for longer, not that the Fed tightens policy.

The BoJ, meanwhile, is navigating upward price and policy normalisation rather than disinflation. Higher oil prices and yen weakness support that journey by lifting near-term inflation while strong wage growth underpins the broader normalisation narrative.

A reassertion of medium-term market dynamics

Stagflation is likely to be negative for both stocks and bonds. But assuming a limited duration for the Middle East conflict, we expect medium-term market dynamics to reassert themselves. We also continue to emphasise the potential for AI to be transformative and to spread its benefits throughout economies, as outlined in our 2026 annual outlook.