At the start of the year, we expected a downshift in economic growth in 2H26 to open the door to monetary policy rate cuts. However, higher oil prices tied to the Middle East conflict raised fears of second-round inflationary effects, prompting markets to price in hikes instead (Exhibit 1). Investors also retain a bitter memory of the 2022 energy shock, when delayed tightening contributed to a sharp inflation episode.

With negotiations under way, the recent reprieve in oil prices may give central banks some breathing room by limiting stagflation risks. That said, the current fragility of the Middle East situation may keep geopolitical risk premium elevated—as last week’s re-escalation illustrates.

The closure of the Strait of Hormuz this year did not trigger a crude oil price spike comparable to that of 2022, when oil peaked at USD 139 per barrel. This time is different: U.S. shale production has risen materially; demand has softened among major consumers such as China; and global petroleum reserves have been released. As a result, the second-round effects of higher crude prices have been more muted than in the prior episode, even after accounting for a geopolitical risk premium. The macro transmission of higher oil prices will also vary by economy, depending on structural factors (e.g., import dependence, pricing power) and the scope for fiscal and monetary responses.

In this note, we assess how major central banks—including those in Asia—may respond to a prolonged period of higher oil prices. In principle, fiscal policy is typically the first line of defense against supply-driven shocks. Central banks, however, may still tighten if higher input costs are clearly being passed through to consumers or if inflation expectations begin to de-anchor—particularly where the mandate places primary weight on price stability.

The U.S. Federal Reserve

At the start of the year, the market priced two U.S. Federal Reserve (Fed) cuts in 2026; at the time of writing, it prices one hike toward year-end. At the most recent Federal Open Market Committee (FOMC) meeting—the first chaired by Kevin Warsh—the dot plot shifted meaningfully hawkish, suggesting less tolerance for inflation overshoots, even when driven by one-off supply shocks.

The impact on U.S. gasoline prices has been more muted than in the prior energy crisis, when prices hit USD 5 per gallon in June 2022, reflecting reduced reliance on energy imports amid higher domestic crude production. The key concern for the Fed is not so much headline consumer price index (CPI), but that core personal consumption expenditures (PCE) inflation (which excludes volatile food and energy) accelerated further in May to 3.4%, underscored by sticky services costs. The risk is that despite a less comparable rise in energy prices this time, second-round effects in energy-intensive sectors could materialize, entrenching underlying price pressures.

However, a de-escalation in the Middle East would likely ease global oil supply constraints, lowering gasoline and transportation costs and helping to contain underlying services-cost pressures. For the rest of the year, our base case is that the Fed keeps rates unchanged if the disinflation trajectory remains intact. Looking into next year, we expect the Fed to consider modest easing if growth slows and inflation moves below 2%—likely alongside a weaker U.S. dollar.

European Central Bank

Before this year’s conflict, wage-driven CPI inflation kept the European Central Bank (ECB) cautious. Looking ahead, wage trackers suggest related underlying pressures may ease. After the conflict began, however, the ECB raised its core inflation projections at the June meeting to 2.5% for 2026 and 2027 (March projections: 2.3% for 2026; 2.2% for 2027), with a profile peaking at 2.7% in 1Q27 before moderating for the rest of the year. Even if wage growth cools in the eurozone, resilient activity and signs that the energy shock is interacting with corporate pricing behavior point to inflation persistence, which could keep the ECB on alert. As a result, the ECB may maintain a restrictive stance—and could still deliver another hike this year—though cuts look more plausible into late 2027 as growth and inflation soften.

Bank of Japan

The Japanese government has passed supplementary budgets to aid households and businesses in navigating higher energy costs including a fuel subsidy program. It is worth nothing that last month’s rate hike—taking the policy rate to its highest level in 31 years—was driven by firmer inflation pressures, stronger wage–price dynamics, and resilient corporate activity. We still expect further hikes, but normalization should be gradual as the Bank of Japan balances the macro backdrop against the effects of fiscal expansion and higher Japanese government bond yields. 

Asia Pacific ex. Japan 

Several central banks in the region have tightened their monetary policy stances in recent months (Bank Indonesia, Bangko Sentral ng Pilipinas (BSP), the Monetary Authority of Singapore, and the Reserve Bank of Australia) in response to elevated crude prices that could feed into domestic inflation, with the markets pricing in further hikes (Exhibit 1). The Reserve Bank of New Zealand joined that group last week, raising its policy rate for the first time since the onset of the Middle East conflict, citing persistent inflation and robust growth momentum. The Reserve Bank of Australia has hiked twice this year—first to address sticky core inflation, and again in response to rising crude prices that may generate second-round effects in domestic goods and services. In the Philippines, the central bank has also raised rates as headline inflation (June headline inflation: 6.4% year-over-year (y/y)) remains above the BSP’s medium-term upper target of 4%, challenging its price-stability mandate. Bank Indonesia aggressively hiked the policy rate by 100 basis points (bps) over the span of a month to anchor inflation expectations and support financial stability, and will likely continue to do so later this year (Exhibit 1). Spillover into core CPI remains limited so far in Korea, but higher oil prices and South Korean won (KRW) depreciation could generate second-round effects—strengthening the case for a hike at the Bank of Korea meeting this week.

Looking ahead, the degree of pass-through from global energy prices into broader CPI components will be a key determinant of policy paths across the region. Even if energy prices ease, some Asian economies now face the risk of El Niño as the next potential inflation source. The largest effects are likely to be concentrated in economies with low inventory buffers and higher starting inflation, such as Vietnam. Overall, we continue to expect a moderate tightening cadence in most parts of the region even as global oil prices ease.

Investment implications

Easing energy prices should reduce the likelihood of an aggressive tightening cycle by lowering the risk of second-round effects. This suggests that central banks may ultimately be less hawkish than current market pricing implies. In our view, even if policy rates rise in response to upside CPI surprises from higher energy prices, we expect any tightening cycle to be shallow given the shock’s likely transitory nature—supportive of equity valuations and, in turn, a pro-risk stance. However, we are cognizant of the sticky underlying inflationary pressures in some major economies that could be a catalyst for rate hikes.

While our view on equities remains constructive, we think portfolios should stay diversified, particularly if the shock intensifies. Current government bond yields offer both downside protection and carry if growth risks re-emerge later this year. This backdrop should favor short-dated bonds and steeper curves—particularly in Europe and parts of Asia—where some central banks are projected to ease next year. By contrast, we see more scope for yields to rise in the U.S. and Japan as fiscal risks remain in focus.

af950b4f-7c34-11f1-968e-d9b7ec5cacf2