Oil topped US$115 a barrel on Monday. Economists say the Iran war has pushed stagflation back onto the global table.

Markets snapped as oil spiked

Global markets reeled early this week after oil benchmarks surged. West Texas Intermediate jumped to levels more than twice January's roughly US$60 a barrel, and Brent hovered near US$99 as trading resumed, sending equities sharply lower in Asia and Europe.

Japan's Nikkei fell by more than 6% and South Korea's Kospi slid over 7% on the same day. The moves followed a succession of supply disruptions in the Gulf and the informal effective closure of the Strait of Hormuz — a shipping choke point through which about one-fifth of seaborne oil flows.

Warren Hogan, economic adviser at Judo Bank, warned the jump is wider than a routine uptick. "There's a good chance that we're seeing one of the most sudden increases in the cost of oil to the global economy ever," he said.

Traders and policymakers have taken note: higher energy costs are already rippling through currencies, bond markets and stock valuations.

One striking detail underlines the speed of the move: U.S. Pump prices rose by roughly 50 cents over a weekend, with the national average hitting about US$3.44 a gallon by Sunday night, according to price trackers. Consumers feel that immediately. Businesses do, too.

How energy shocks flow into inflation

When crude prices go up, costs rise throughout the economy. Transportation costs climb, and companies pass those expenses to consumers by raising prices on goods and services. Fertilizer and gas supply strains add upward pressure on food and industrial costs.

Royal Bank of Canada economists modelled the effect: if oil stayed at US$100 a barrel, U.S. Consumer inflation could jump to roughly 3.7%, they found. The bank's estimate underlines how even a few dollars' move in oil can change headline inflation projections materially.

This mix of rising costs and falling demand is a classic sign of stagflation. Diane Swonk, chief economist at KPMG, said the current mix of shortages and price increases amounts to multiple supply shocks that are different from ordinary cyclical inflation. "The closing of the Strait of Hormuz & resulting surge in oil prices is more than an oil shock," she wrote. "Costs are so large that they simultaneously prompt cost-push price hikes even as firms become more reluctant to hire."

She added a stark warning on policy outcomes: "If the economy sees a bout of stagflation, the only clear way out is a deep recession," Diane Swonk wrote. That assessment has forced investors to rethink the path for central banks.

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Central banks face a sharper bind

Central banks typically change interest rates to control inflation or boost growth.

But right now, the shocks are supply-driven, not from strong demand. So, monetary authorities face a tough choice: raise rates to fight inflation or cut them to support growth and jobs.

European officials are sounding the alarm. Valdis Dombrovskis, European Commission Executive Vice-President and Economy Commissioner, said it's clear policymakers face a real stagflation risk. Croatian central bank governor Boris Vujcic — set to become vice-president of the European Central Bank in May — told reporters that while stagflation hadn't arrived, the bloc was "moving in that direction; how far we will go is very difficult to predict."

ECB projections highlight the range of outcomes. In its central scenario, the bank still expects inflation to slow to about 2.6% this year with GDP growth near 1.9%. But in a severe scenario tied to an entrenched conflict, eurozone inflation could top 6% by 2027, the ECB's modelling shows.

That gap is why policymakers are nervous. ECB President Christine Lagarde has said the bank stands ready to raise interest rates if needed. The implication is clear: the eurozone faces the prospect of tighter monetary policy even as growth risks rise.

Policy paths and downside risks

Markets have started to expect tougher policies in some regions. Short-term borrowing costs in Europe have risen as investors factor in a higher probability of ECB action. In the U.S., investors who had been pencilling in rate cuts later this year are now rethinking that view; some models show the chance of a Fed hike in the second half rising.

Not everyone agrees on timing. Goldman Sachs pushed back against the idea that the Fed will cut rates this year, arguing a cut in 2026 is still unlikely. But Diane Swonk expects rate moves to be more restrictive later in the year, a sign the Fed may shift from easing bets to a firming stance if inflation pressures persist.

If stagflation worsens, the impact would be widespread. Joaquín Maudos, professor at the University of Valencia, warned: "If it escalates, stagflation, further interest rate hikes, increased loan defaults, and so on are anticipated." Higher borrowing costs would squeeze households and businesses already coping with higher energy and food bills. Banks could see more non-performing loans, and governments might face bigger fiscal bills to shield vulnerable households.

Countries with limited fiscal room could feel the pain even more. Rising inflation and weaker activity would force painful trade-offs: support growth and risk higher prices, or fight inflation and risk a sharper contraction in output and jobs.

Historical frame and what might happen next

Economists point to the 1970s oil embargoes and wage-price spirals as the last big episode of low growth and high inflation. That historical anchor helps explain the alarm; policy tools then were limited and social costs were severe.

Today the global economy is more services-oriented and central banks have tools they lacked half a century ago. Still, the combination of a tight labour market in some economies and sticky wages makes the present mix hard to handle. Swonk points out that if firms face big cost increases and can't lower wages quickly, layoffs rise instead — and unemployment climbs even as prices keep rising.

What happens next depends on the conflict's path and whether key trade routes remain disrupted. If energy and commodity flows normalize quickly, markets could relax and inflation trends could ease. If the war proves protracted and more supply lines get hit, central banks may have to choose more aggressive rate paths that feed through to economies and asset prices.

Investors and policymakers will watch oil, shipping lanes and diplomatic signals closely in coming weeks. For now, markets are pricing a wider range of outcomes than they were just weeks ago. Volatility is back.

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"If the economy sees a bout of stagflation, the only clear way out is a deep recession," Diane Swonk, chief economist at KPMG, wrote.

This article was created with AI assistance.