War shock tests central banks’ resolve

A widening conflict in Iran is rapidly feeding through to the global economy, presenting central banks with a familiar but deeply uncomfortable dilemma: rising inflation driven by energy shocks, alongside weakening growth.

Speaking on SiriusXM Business Briefing, Dr Linda Yueh, Adjunct Professor of Economics at London Business School, said the scale and speed of the impact is already evident across Europe.

“Around a fifth of global shipping passes through the Strait of Hormuz,” she noted. “For the UK, about half of aviation fuel comes from that region. In Europe, there are estimates supplies could run down within months. This is not a distant shock, it is immediate.”

The inflationary effects have been swift. UK inflation has climbed to 3.3 per cent, while the eurozone has reached 2.6 per cent, both above target. Yet, despite this, the Bank of England and the European Central Bank are widely expected to hold interest rates steady.

The reason is straightforward, if unsatisfying. “This is a supply-side shock,” Yueh explained. “When energy and food prices jump, there is very little central banks can do except manage expectations.”

That restraint is shaped by recent history. Policymakers were slow to recognise the persistence of inflation following Russia’s invasion of Ukraine. But acting too aggressively now risks compounding another problem: weak demand.

Core inflation, which strips out volatile energy and food prices, is falling. That signals a slowing economy. “If they raise rates,” Yueh said, “they risk weakening activity even further. These will be long meetings, even if the decision is to hold.”

The pressure is intensified by the cumulative effect on households. UK prices are roughly 30% higher than five years ago, a sustained squeeze that is now showing up starkly in sentiment data. Consumer confidence has fallen to a record low.

“Five years of rising prices and subdued growth have eroded disposable incomes,” Yueh said. “Add to that uncertainty over interest rates and mortgages, and it is not surprising households feel under strain.”

If monetary policy is constrained, fiscal policy becomes the main lever. Yet governments face limits of their own. Debt levels hover around 100 per cent of GDP in major European economies, while growth forecasts for countries such as the UK and Germany are under one per cent.

“There is a lot of discussion, but not much spending yet,” Yueh observed. “Supporting households likely means more borrowing, but governments are cautious. Raising taxes in a weak economy is also difficult.”

The result is a policy bind on both sides: central banks wary of tightening into weakness, and governments hesitant to spend into high debt.

Against this fragile backdrop, stability in global financial leadership matters more than ever. News that a US Department of Justice probe into Federal Reserve Chair Jerome Powell has been dropped removes one source of uncertainty at a sensitive moment.

“Markets prefer boring central banks,” Yueh said. “In times of volatility, you want predictability, independence and clarity. Removing that uncertainty is helpful.”

For now, markets appear to agree, reacting calmly to the development. But the broader picture remains unsettled.

“If the conflict continues,” Yueh warned, “we may see governments turn more decisively to borrowing, and central banks forced to reconsider their stance. Much will depend on how this shock evolves.”

In the meantime, policymakers face a narrow path: holding steady in the face of rising prices, even as the ground beneath growth continues to soften.

To listen to the entire discussion, click here