Trump is holding the world hostage

The world’s four most important central banks, and a slew of others, meet this week. With the US-Israeli assault on Iran as the backdrop, they’ll provide some perspective on how they might respond to what the International Energy Agency has labelled the biggest disruption to the oil market in history.

The US Federal Reserve Board, the European Central Bank, the Bank of England and the Bank of Japan will all hold meetings this week, along with our Reserve Bank, the People’s Bank of China, the Bank of Canada and central banks in Brazil, Indonesia, Switzerland, Sweden and Russia.

The key meeting will be the Fed’s. Even though it isn’t expected to make any change to US monetary policy, its signals on the implications of the oil shock for the US economy and for US interest rates will be influential, given the significance of the US economy and, perhaps more importantly, its financial markets to the rest of the world.

The war in Iran has caused oil prices to soar, from about $US65 a barrel before tensions in the Middle East began to more than $US100 a barrel, with flow-on effects to petrol and diesel prices.

The effective closure of the Strait of Hormuz has also disrupted the supply and pricing of refined products, LNG, fertilisers, metals and other commodities. The region’s aviation industry – the world’s busiest hubs are in Dubai and Doha – has essentially been closed to passenger and cargo traffic.

Those energy price rises – US petrol prices have rocketed from under $US3 a gallon to about $US3.70 a gallon, and diesel from $US3.65 to $US4.97 a gallon, with similar or even greater price increases elsewhere in the globe – will feed into transport costs and subsequently consumer prices and inflation rates.

The interruption to supplies of energy and other critical commodities is akin to the supply chain shocks during the pandemic, which ignited inflation rates around the world.

While the depth of those effects depends on the duration of the conflict, they are already bleeding into costs and will be reflected in end-prices, inflation rates and economic growth.

In Australia, the Reserve Bank was already expected to raise rates, again, on Tuesday to respond to a rekindling of the inflation rate. The spike in petrol prices makes that near-certain.

In the US, while there is no expectation of a rate move at this week’s meeting, where markets previously priced in two 25 basis point cuts this year they are now factoring in only one. In the bond market, yields have already risen, with the two- and 10-year yields both up about 34 basis points from their prewar levels.

The sharemarket, initially relatively calm, is now down nearly 5 per cent.

The Fed is in an awkward position as the war has come while the US economy is in a delicate state. Inflation was edging up and was well above the Fed’s 2 per cent target, and the unemployment rate was also rising, before the airborne assault began.

Indeed, there was a dump of economic data late last week that showed the economy was in a significantly worse state than previously appreciated.

The Fed’s preferred inflation measure, the core personal consumption expenditures price index, came in at 3.1 in January. Last October, the reading was 2.7 and appeared to be on a gradual downward trend.

The University of Michigan’s consumer sentiment index fell for the first time in four months in this month’s survey, from 56.6 to 55.5. With consumption contributing almost 70 per cent of US GDP – it is the driver of growth in the US – that’s not a good sign.

Earlier jobs data showed there was a net loss of 92,000 US jobs in February. The jobs market, particularly in manufacturing, was weakening throughout last year and appears to have deteriorated further since the start of this year.

The biggest shock in last week’s data, however, was a revision to the December quarter’s growth in the economy.

When it was initially posted as 1.4 per cent, Donald Trump and US Treasury Secretary Scott Bessent claimed the numbers showed the economy could grow at a rate of 4 per cent or more.

Trump hailed that number as the start of the “Trump economic Golden Age”, while Bessent referred to a “supply-side boom” and spoke of the potential for the economy to grow at far higher rates without any inflationary impacts.

That December quarter rate of GDP growth was halved last week, to an anaemic 0.7 per cent, even before the war began and oil and gasoline prices soared. US economists are now discussing the prospect of a recession.

Certainly, stagflation – rising inflation but a slowing economy – is more of a distinct possibility than it was when it was first discussed last year, when the focus was on Trump’s tariffs.

The dilemma that the Fed and its peers around the world have been hoping to avoid – rising inflation and falling employment and growth – is now squarely before them.

For the US, the economic picture is, thanks to Trump’s tariffs and war, messy and threatening and, while he continues to berate Fed chair Jerome Powell for not lowering US interest rates, the outlook is too uncertain for the Fed to pay any heed to him.

It is of course, open to Trump to end the war. He could declare victory (in effect, he already has) and cease the attacks, even though the initial goals of regime change and the securing of Iran’s stockpile of enriched uranium haven’t been achieved.

That wouldn’t, however, bind Israel, nor would it by itself lead to the reopening of the Strait of Hormuz or end Iran’s attacks on its neighbour’s military and energy infrastructure – its asymmetrical response to a conflict it couldn’t have responded to conventionally, given the disparity in weaponry.

Even if both sides of the conflict did end it this week, considerable damage to the world economy will have already been locked in.

With Trump closing in on a new round of tariffs on major economies to replace those struck down by the US Supreme Court (and the 10 per cent rate imposed under a different statute as an interim measure), the damage Trump has done to an economy where, before his return to the White House, the inflation rate had been dropping steadily, the employment market was growing and growth was solid is largely self-inflicted.

When the Fed held its last meeting in January, the members of its open market committee would have been relatively comfortable with the economic settings. Inflation was tracking down, albeit slowly, while the labour market appeared relatively stable and economic growth quite strong.

Now it faces a real threat to both inflation and growth and the challenge of deciding which to prioritise.

The longer Trump takes to declare his victory, hollow or otherwise, and end the conflict and for the strait to reopen, the more central bankers around the world will confront that same dilemma as the destructive waves from the oil shock roll through their economies.

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