Australia Moves to Tighten Amid Middle East Oil Shock as Market Yields Rise While Central Banks Weigh Their Next Steps

Australia Begins Monetary Tightening in Response to Middle East-Driven Uncertainty
Other Major Central Banks Also Grapple With the Path of Monetary Policy
Markets Price in Tightening Expectations as Sovereign Yields Rise in Tandem

Australia has pulled out the rate-hike card. With international oil prices surging on the back of conflict in the Middle East and inflationary pressure intensifying, it has become the first among major economies to begin tightening monetary policy. Beyond Australia, a host of countries including the United States, Japan and South Korea are cautiously assessing the direction of monetary policy, while market interest rates are already moving higher in anticipation of tighter conditions.

Australia’s Policy Rate Increase

On the 17th local time, the Reserve Bank of Australia (RBA), at its monetary policy meeting, decided to raise its benchmark interest rate by 25 basis points to 4.10% annually. Following last month’s move, it marked a second consecutive monthly increase, lifting the policy rate to its highest level since April last year. In the monetary policy statement released that day, the RBA explained the rationale behind the decision, saying, “Inflation is likely to remain above target for some time, and several risk factors, including inflation expectations, are judged to be tilted to the upside, making it appropriate to raise the cash rate target.”

Australia’s economy is, in fact, being squeezed by a confluence of risks. Domestically, overheating conditions remain in place. Australia’s consumer price inflation in January stood at 3.8%, above the upper end of the RBA’s target band of 3%, while core inflation reached 3.4%, the highest level in 16 months. The unemployment rate remains at 4.1%, near historic lows, and fourth-quarter GDP growth last year came in at 2.6%, above the country’s potential growth rate of 2%. On this point, Paul Bloxham, HSBC’s chief economist for Australia, New Zealand and global commodities, said in an interview with CNBC that “the output gap is positive, inflation is too high, and unemployment is low,” analyzing that the main driver of this rate increase lay in domestic Australian factors.

The rise in oil prices stemming from conflict in the Middle East also appears to have influenced the rate decision. Since the United States and Israel launched strikes on Iran on the 28th of last month, the Strait of Hormuz, through which 20% of global oil supply passes, has effectively been blocked, while multiple energy production hubs in Gulf states have also come under attack. In effect, disruptions have emerged across both crude production and transportation. As a result, West Texas Intermediate crude has surged more than 50% over the past two weeks, breaking above USD 100 per barrel, while gasoline prices in Australia have risen by about 58 cents per liter. At a press conference following the rate increase, RBA Governor Michele Bullock voiced concern over the oil-price surge, saying that “rising fuel prices carry a significant risk of causing inflation expectations across the economy to become unanchored, rather than proving merely temporary.”

Rate Trajectories of Major Economies Amid Uncertainty

Middle East-driven energy supply risks are influencing monetary policy well beyond Australia. In the United States, for example, the benchmark rate was kept unchanged for a second consecutive meeting at 3.50% to 3.75% as of the 18th. In its statement released that day, the Federal Reserve said, “Economic activity has been expanding at a solid pace, but inflation remains somewhat elevated,” adding that “the economic outlook remains highly uncertain.” It also directly referred to geopolitical risk, stating that “the impact of developments in the Middle East (the Iran war) on the U.S. economy remains uncertain.”

The Bank of Japan (BOJ), too, on the 19th kept its benchmark rate unchanged at 0.75% following its monetary policy meeting. Japan’s current policy rate, set after a rate increase in December last year, is the highest since 1995, marking a 30-year peak. Alongside the decision to hold rates steady, the BOJ said it must “closely monitor the future course of developments in the Middle East and fluctuations in crude oil prices and their impact on Japan’s economic activity and prices.” Regarding future policy operations, it added, “Given that real interest rates are currently at significantly low levels, if the outlook for economic activity and prices presented in the January Outlook Report is realized, the central bank will continue raising the policy rate and adjust the degree of monetary accommodation.” In the January Outlook Report, Japan’s core inflation forecast for this year stood at 1.9%, with economic growth projected at 1.0%.

Markets are effectively treating a BOJ rate increase by July as a foregone conclusion. The view is that any further delay would lift import costs, push up inflation expectations, weaken the impact of past rate hikes, and deepen both price pressure and yen depreciation. On this matter, Naomi Fink, chief global strategist at Amova Asset Management, observed that “tightening carries the risk of deepening a domestic slowdown, but postponing tightening could intensify yen weakness.” Chiyuki Takamatsu, chief economist at Fukoku Mutual Life Insurance, likewise assessed that “it will be difficult for the BOJ to slow the pace of rate increases if it wants to prevent further yen depreciation.”

The Middle East conflict is also emerging as a major variable in the Bank of Korea’s monetary policy decisions. Given South Korea’s heavy dependence on external energy sources, any sharp rise in international oil prices exerts substantial upward pressure on prices. Should the situation become protracted, there is also a risk that inflation and economic stagnation could occur simultaneously, pushing monetary policy into a dilemma. Lee Soo-hyung, a member of the Bank of Korea’s Monetary Policy Board, said at a press briefing on the 17th that “the Iran situation poses upside risk to inflation and downside risk to growth,” while adding that “it is still difficult at this stage to determine how much of an impact it will actually have on the Korean economy.” He also said the Monetary Policy Board’s six-month rate outlook, or dot plot, could change in May.

Market Yields Trace an Upward Curve

Against this backdrop, government bond yields across major economies are already tracing an upward curve. Expectations of tighter policy are now being meaningfully priced into market rates. On the 18th, the yield on the 10-year U.S. Treasury at one point rose to 4.26% intraday. That is notably higher than the roughly 3.97% level seen before the Iran war. The yield on the policy-sensitive 2-year U.S. Treasury also climbed as high as 3.77%, up 10 basis points from the previous session. After the Fed announced its rate hold, however, the gains narrowed, with the 10-year trading in the 4.218% to 4.228% range and the 2-year at 3.710% to 3.714%.

Government bond yields in major European economies are also moving higher in lockstep. On the same day, the yield on the UK 10-year gilt rose about 4 to 5 basis points from the previous trading session to 4.68% to 4.74%. Germany’s 2-year government bond yield, which is particularly sensitive to European Central Bank policy, jumped 7.40 basis points to 2.4644%, while France’s 2-year yield also rose around 7 basis points to 2.57% to 2.58%. This is interpreted as the result of the Middle East conflict increasingly morphing into an “economic war” centered on attacks on energy infrastructure, thereby underscoring Europe’s energy vulnerability.

Japan’s 10-year government bond yield also rose from around 2.1% in early March to about 2.26% on the 18th, though it retreated to around 2.21% on the 19th, showing a temporary bout of weakness. With tension building in the market ahead of the BOJ’s policy decision, the move appears to have been driven by profit-taking after the sharp run-up. Financial circles and others, however, largely view the decline as a short-term adjustment rather than a trend reversal, given the high likelihood that the BOJ will raise rates before long.