Fresh hostilities in the Gulf region have brought stagflation back into the conversation, dashing hopes that a temporary agreement between the U.S. and Iran would be enough to shield the global economy from the toxic combination of high inflation and weak growth.
Oil prices have climbed back to $100 a barrel, European natural gas futures are headed for their largest monthly gain since March, and government borrowing costs have reached multi-year peaks as inflation anxiety mounts and tensions continue to escalate.
Trade disputes are piling onto the uncertainty already weighing on consumers, businesses, and investors. On Friday, the U.S. imposed fresh tariffs of 10% and 12.5% on imports from 60 trading partners — including the European Union and China — a move that is expected to push prices even higher.
“Stagflation risk has been very much there for each economy since March, in different ways,” said Alessia Berardi, head of global macroeconomics at Amundi Investment Institute. She added that the latest widening of the conflict “increases the risk of stagflation for sure.”
Energy Prices Leading the Charge
Energy costs remain the primary force behind near-term inflation expectations, which is why this week’s price spike has sent shockwaves through financial markets.
Brent crude oil had dropped as low as $70 a barrel in early July amid optimism over a ceasefire, but it touched $100 again after Yemen’s Houthis claimed they struck two Saudi oil tankers in the Red Sea — expanding shipping disruptions beyond the Strait of Hormuz. Oil is now up nearly 40% in July, on pace for its biggest monthly increase since March. Benchmark European natural gas futures have also hit their highest levels since March.
Inflation Expectations on the Move
Although U.S. inflation for June came in below expectations last week, that relief was short-lived. Higher energy prices this week pushed government bond yields sharply higher across the U.S., Japan, and Germany.
Kristjan Kasikov, Citi’s head of FX quant investor solutions, noted that markets have historically been slow to fully account for swings in agricultural and energy commodity prices. “Market participants expect this rise in commodities to be transitory, but it is worth watching,” he said.
Analytics firm Kpler estimates that roughly one-third of the world’s fertilizer supply passes through the Strait of Hormuz, suggesting food prices could stay elevated for an extended period — hitting vulnerable emerging markets especially hard. This year’s El Niño weather pattern is also contributing to upward price pressure.
Central Banks Caught in a Bind
In response to these pressures, traders have renewed their bets that central banks will be pushed into additional interest rate increases to keep inflation in check.
Markets are pricing in approximately two more quarter-point rate hikes from the European Central Bank before year-end, on top of its move in June. The ECB held rates steady on Thursday but signaled that further tightening could be coming.
In the U.S., rate hike expectations had softened following last week’s inflation data, but they quickly rebounded. Markets are now anticipating roughly two additional increases by January. U.S. inflation has exceeded the Federal Reserve’s 2% target for five consecutive years.
The problem for policymakers — particularly in energy-importing regions like the euro area — is that raising rates also acts as a brake on economic growth, which is already being squeezed by the energy shock.
Andrew Sheets, global head of fixed income research at Morgan Stanley, warned that Europe faces a particularly difficult situation. “The European Central Bank has looked more willing to raise rates into oil-driven inflation than the Federal Reserve,” he said. “That has the potential to be a double hit where Europe faces tighter financial conditions through higher energy prices and tighter financial conditions through tighter policy.” The euro fell to three-week lows below $1.14 just as oil touched $100 on Thursday.
Global Growth at Risk — Including the U.S.
The growth-slowing dimension of stagflation may already be taking hold. The World Bank’s chief economist told Reuters this week that the conflict could drag global economic growth down to as low as 1.3%, compared with 2.9% last year.
Asia, which sources most of its oil from the Gulf, is especially at risk — particularly nations in South and Southeast Asia that are struggling to absorb higher energy costs. Japan can afford to pay more, but with its yen sitting at four-decade lows against the dollar, the costs are steep. The value of Japan’s imports hit a record high in June, further stoking inflation there.
While the United States is less exposed due to its status as an energy exporter, it is not entirely insulated. Average gasoline prices at the pump have climbed back above the “psychological threshold” of $4 per gallon — a painful reality during the peak summer driving season. Meanwhile, combined fuel costs at four major U.S. airlines were nearly $8 billion higher than the same period a year ago.
Homebuyers are also feeling the strain. Rising U.S. Treasury yields pushed the interest rate on the most widely used type of home mortgage to its highest level since last August.
