Negotiations between the United States and Iran have by now settled into a remarkably efficient pattern. The two sides reach an agreement, declare the talks constructive, break the agreement, attack each other, and then sit down again to discuss the next constructive agreement. In June, they signed a memorandum of understanding intended to extend the ceasefire and gradually reopen the Strait of Hormuz. Then the shooting resumed. At the end of July, both sides once again paused their attacks while Oman mediated between Washington and Tehran. Among the issues under discussion is which ships should sail along the Omani coast and which should pass through Iranian waters. Diplomacy, after all, is the art of spending several weeks resolving problems that would scarcely have existed without the preceding escalation.
For capital markets, the crucial point is that this military choreography is reflected directly in the oil price. As the conflict escalated, traffic through Hormuz largely ground to a halt and Houthi attacks also threatened the route through the Red Sea, Brent crude temporarily rose above $100 a barrel. After the pause in attacks, the price collapsed within a single day and at one point traded at around $86. The oil market is therefore trading less on long-term demand than on the latest press release from Washington, Tehran or Muscat.
The problem is not merely the high price, but its persistence and transmission. Rising energy and transport costs hit companies, consumers and inflation expectations at the same time. What begins as an external supply shock can develop into a broader inflationary impulse if companies pass on higher costs and workers demand compensation for lost purchasing power. In the United States, inflation as measured by personal consumption expenditures most recently stood at 4.1 per cent, more than twice the Federal Reserve’s target. The energy shock is also colliding with existing sources of price pressure, including tariffs and heavy infrastructure investment.
It is therefore naturally reassuring that Fed chair Kevin Warsh has chosen precisely this moment to dispense almost entirely with forward guidance. Investors are free to guess whether the central bank considers rising inflation, weakening growth or high capital-market yields to be the greater problem. The result was a marked steepening of the US yield curve. The yield on 30-year Treasury bonds rose at one point to 5.24 per cent. Warsh argues that the market has already tightened financial conditions, sparing the Fed from having to act itself. Outsourced monetary policy is also a form of efficiency.
The European Central Bank, by contrast, has already acted, raising its policy rate to 2.25 per cent in June. From today’s perspective, that was the wrong decision. The ECB responded to an imported energy shock that higher European interest rates can neither prevent nor reverse. It cannot reopen the Strait of Hormuz, but it can at least make European credit more expensive.
The eurozone’s 0.4 per cent growth in the second quarter should therefore not be mistaken for the start of a strong recovery. Germany, France and Italy each managed growth of just 0.2 per cent. Much of the momentum came from state-supported investment, fiscal programmes and a weaker euro. It did not come from a convincing revival in private consumption or business investment. The increase is welcome, but it is not yet a self-sustaining upswing.
A further rate increase in September risks choking off precisely this fragile development. Higher financing costs would hit construction, industry and investment, while the source of the inflationary pressure lies outside the ECB’s control. Europe would then be fighting expensive oil with weaker growth. That may be formally consistent, but it is economically unconvincing.
The pressure on Washington and Tehran to reach an agreement nevertheless remains enormous. Iran needs functioning export routes, the United States wants lower petrol prices ahead of the midterm elections, and the rest of the world has little interest in seeing a crucial energy corridor used indefinitely as geopolitical bargaining leverage. Neither side can absorb the economic damage without limit.
There is therefore reasonable hope for at least a durable interim solution during the remainder of the year. A gradual reopening of the strait would reduce the risk premium in oil prices, ease inflationary pressure and allow central banks to do less damage. That would not yet amount to peace. For the economy and the markets, it would be enough for now if geopolitics could simply learn to stay in its lane.
