The plan was simple and, for once, it was working. After two years of aggressive rate hikes to combat post-pandemic inflation, the world’s major central banks were engineering a coordinated easing cycle. Inflation was coming down. Growth was stabilising. The soft landing was within reach. Then the bombs started falling on Iran, and the plan fell apart.
Money markets are now pricing in rate hikes by the European Central Bank as early as next month. Not cuts. Hikes. The shift is extraordinary in both its speed and its scale. As recently as February, the ECB was expected to reduce rates two more times before the end of the year. Now traders are betting it will raise them instead. The pivot from dove to hawk has happened in less than four weeks.
The Inflation Trap
The problem is brutally straightforward. Oil prices are up 45% since late February. Gas prices are up 55%. These are not temporary fluctuations that central bankers can “look through” — the standard euphemism for ignoring price spikes and hoping they go away. The Strait of Hormuz is physically blockaded. Supply is not coming back until the war ends or an alternative route is established, neither of which appears imminent.
Energy costs feed into everything. Transport. Manufacturing. Food production. Heating. When energy prices spike, headline inflation follows within weeks and core inflation follows within months. Forecasters have already raised their 2026 inflation projections and lowered their growth forecasts “pretty much across the board,” as S&P Global put it in its latest outlook.
Central Bank by Central Bank
The ECB faces the most acute dilemma. The eurozone economy was already stagnant before the war. Germany has been in or near recession for two years. Southern Europe was showing signs of life, but not enough to absorb a major energy shock. Raising rates into a weakening economy is the textbook definition of a policy error — but allowing inflation to re-accelerate after spending two painful years bringing it down is equally unacceptable.
The Bank of England is in a similar bind. The UK economy entered 2026 with barely visible growth, unemployment at a five-year high, and businesses already complaining about the cost of Labour’s employment reforms. A rate hike would tighten conditions further. But with energy bills set to jump 20% in July and inflation expectations creeping upward, holding steady risks losing credibility.
Even the Bank of Japan, which has spent three decades fighting deflation and has only just begun tentatively raising rates from near-zero, cannot ignore what is happening. Japanese firms are heavily exposed to Gulf energy imports, and the yen’s weakness against the dollar is amplifying the cost of those imports. A rate hike is no longer unthinkable — it is being actively discussed.
The Fed’s Bind
The Federal Reserve, which paused its easing cycle last week, faces the most politically charged version of this dilemma. Raising rates during a war that the President started would set Chair Jay Powell on a direct collision course with the White House. Not raising them while inflation rebounds would undermine the Fed’s credibility with markets. Powell has said the Fed will be “data-dependent.” The data is about to get very uncomfortable.
Six months ago, the biggest risk in global monetary policy was cutting too slowly and choking off a recovery. Today, the biggest risk is that the recovery has been killed by a war, and the only tool available — interest rates — will make it worse no matter which direction it is moved. That is not a policy challenge. It is a policy nightmare. And the central bankers who spent years carefully building the conditions for a soft landing are watching it crater in real time.