Inflation, monetary policy expectations and market implications amid Middle East developments

Recent escalations in the Middle East have renewed volatility in energy markets, with implications for inflation dynamics and monetary policy expectations across major economies. While headline inflation has begun to edge higher in parts of the euro area and the UK, the transmission into core inflation and policy decisions remains uncertain. In this blog, we explore how recent developments are being reflected in inflation data, market based policy expectations and investor positioning across the euro area, the UK and the United States.

A series of inflation data releases in the euro area pointed to a modest uptick in inflation, reflecting the impact of the conflict in the Middle East on oil and gas prices. Overall inflation in the 21 countries sharing the euro rose to 2.5% in March – up from 1.9% the previous month. Energy costs increased by 4.9%, while core inflation edged lower to 2.3% from 2.4% according to Eurostat. To date, inflationary pressures have remained largely concentrated in energy and food prices, with limited spill over into core inflation. However, higher transportation costs may place upward pressure on agricultural prices over time, reflecting increased costs from petroleum-based inputs. 

Inflation data released last week also showed that Germany’s year-on-year CPI increased from 2.0% in February to 2.8% in March. Core inflation, excluding food and energy, remained unchanged at 2.5%. Services inflation, which had been elevated prior to the conflict, was unchanged at 3.2% for a third consecutive month. Risks to core inflation remain skewed to the upside, as second-round effects from higher energy costs may gradually feed through. Higher energy prices are expected to reduce Germany’s income by approximately EUR 50 billion over the year, reflecting higher spending on imported energy. 

The table below shows ECB EUR €STR OIS-based probabilities following the conflict and the ceasefire announcement:

Subsequent market pricing reflects expectations of a rate hike at the June meeting, with an additional hike priced in for September. The probability distribution table indicates a 26.85% likelihood of the ECB rate reaching 2.75%. Swap market pricing suggests that further tightening remains a possible outcome. Separately, the German Bundesbank has highlighted upside risks to inflation, with average inflation expected around 2.8% in 2026 and potentially approaching 3% in the near term, reflecting higher fuel and energy prices.

Among G7 economies, the UK appears relatively exposed – given that around 25% of electricity generation depends on natural gas. The UK has also recorded year-on-year inflation of around 3% in recent months. At the same time, market expectations for Bank of England policy have shifted, moving away from previously anticipated rate cuts earlier in the year. 

Bank of England Governor Andrew Bailey noted last week that markets may have been “getting ahead of themselves”. He acknowledged that some pass-through of higher energy costs by firms is likely, while also highlighting ongoing economic weakness. This contrasts with developments in 2022, when energy prices rose sharply following Russia’s invasion of Ukraine. Business sentiment in the UK remains subdued, which may limit companies’ ability to raise prices. However, the Food and Drink Federation (FDF) has indicated that food and non-alcoholic drink inflation – previously expected to ease to 3.2% by December 2026 – could rise above 9% under current assumptions. 

The table below indicates BoE SONIA OIS-based probabilities following the conflict and the ceasefire announcement:

Despite an earlier repricing away from rate cuts following the escalation, subsequent market moves after the ceasefire announcement now imply that a rate cut is priced for June, with a further cut expected in September. The Bank Rate is projected to reach 4.25% by the end of the year. Higher interest rates are expected to weigh on household consumption and the government budget deficit, particularly as unemployment has been rising. Headline inflation is expected to increase in the second half of the year and may peak at 3.6% in September 2026, reflecting higher wholesale energy prices.

The table below demonstrates Fed funds futures-based probabilities following the conflict and the ceasefire announcement:

In the US, market expectations continue to imply a Federal Reserve rate cut, although only one cut is currently priced in for June next year. Compared with the UK and euro area, recent developments appear to have had a more limited impact on US monetary policy expectations. A further consideration is the forthcoming appointment of a new Federal Reserve Chair, which may influence policy expectations over time. Stagflation risks remain comparatively lower, with US economic growth in 2026 expected to exceed 2%, outperforming projected growth in the UK and euro area. 

US GDP growth continues to be supported by capital expenditure in technology-related sectors. A firmer US dollar may help moderate imported inflation pressures, while lower reliance on imported gas and oil provides additional insulation. However, historical patterns suggest that Fed funds futures may at times misprice the future policy path, which can result in market dislocations.  

Overall, economic outcomes will depend on the duration and evolution of the conflict. Central banks may face a more complex policy environment should inflation begin to feed through more persistently into core measures. Growth in both the UK and Germany is expected to remain subdued. In this context, investors have shown a preference for perceived safe-haven assets such as CHF and USD, alongside money market instruments and cash. A stronger US dollar could contribute to imported inflation, particularly for economies reliant on energy imports. Countries with a high dependence on gas for electricity generation, including the UK, Italy, the Netherlands and Japan, remain among the more exposed.