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Faced with higher headline inflation driven by an energy shock, in this case the war with Iran, central bankers instinctively reach for higher interest rates in an effort to curb inflation. Many economists disagree with this approach, arguing that using the blunt instrument of monetary tightening to address a supply-side problem merely creates additional economic damage.

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Higher energy prices undoubtedly raise headline inflation, but they also weaken consumer demand. As households spend more on petrol, heating and electricity, they have less disposable income available for other goods and services. In effect, higher energy costs act as a tax on consumers, reducing demand across the wider economy. There is therefore little logic in compounding the squeeze by increasing mortgage costs through higher interest rates. Moreover, "core" inflation—which excludes the volatile prices of energy and food—has changed little since the conflict began, suggesting that the underlying inflationary trend remains largely intact.

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More interestingly, the direction of oil prices over the medium term may be lower rather than higher. Traditionally, oil prices have risen whenever geopolitical tensions threatened supplies from the Middle East. With the Strait of Hormuz carrying around one-fifth of globally traded oil, any disruption has historically prompted fears of shortages. Today, however, that assumption is becoming less convincing.

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For many years, the Gulf's oil-producing nations have anticipated the risk of disruption and invested heavily in alternative export routes. The UAE's Habshan–Fujairah pipeline enables crude exports to bypass the Strait of Hormuz, while Saudi Arabia's East–West Pipeline transports oil directly to the Red Sea. The UAE has also begun work on a second pipeline that aims to double export capacity by 2027. As these alternatives expand, markets have less reason to price in the risk of severe supply disruption.

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At the same time, incremental demand for crude oil has weakened, particularly in China. Much of China's oil imports were previously refined into petroleum products for export, but as export growth has slowed, domestic investment has increasingly shifted towards renewable energy and electric vehicles. Softer Chinese demand, together with rising oil production in the United States, Brazil, Guyana and Canada, has left the global oil market structurally well supplied.

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Combined with the continued expansion of renewable energy, these trends lead the commodity research firm Queen Anne's Gate Capital to conclude that the global oil market is moving towards a growing surplus, leaving oil prices vulnerable to a sustained decline over the coming years. If that proves correct, the case for maintaining, let alone increasing, interest rates in response to an oil-price shock becomes considerably weaker.

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Comments from James Scott-Hopkins, Founder of EXE Capital Management.

The views are those of the author only.

The above does not constitute a recommendation to buy specific funds or assets. The value of investments can fall as well as rise. Past performance is no guarantee of future returns.‍