Since the Reserve Bank of Australia (RBA) began cutting interest rates in February, investors have been betting that rates will continue to trend lower.
Over the past week, oil has surged 14% to US$73.27 per barrel at the time of writing, as investors prepare for potential disruptions due to conflict in the Middle East.
Last Friday, Israel launched a strike on Iran's nuclear facilities. Despite calls for de-escalation, both sides carried out multiple missile attacks over the weekend. Today, US President Trump called for the evacuation of Iran's capital amid escalating strikes and abruptly left the G7 meeting to address the conflict.
There is potential for Iran to close the Strait of Hormuz, a key shipping passage that transports around 20% of the world's oil. Iran has previously threatened to close the Strait in response to regional conflict.
According to the Australian Financial Review, economists warn that further escalation of the war between Israel and Iran could cause the oil price to potentially quadruple or even quintuple.
How could this affect interest rates?
The RBA's main goals are to maintain price stability (low and stable inflation) and full employment in Australia. Therefore, when setting interest rates, the RBA closely looks at inflation data.
Energy (oil) is a key component in the Consumer Price Index (CPI). Should there be sustained disruption in the Strait of Hormuz, oil prices are likely to shoot up. While this would cause CPI to rise, it's unclear how the RBA would treat this increase.
Yesterday, Treasurer Jim Chalmers warned that the war in the Middle East would have substantial economic consequences.
Higher oil prices do pose a risk to the inflation outlook, but they also pose a risk to global growth…The global economy is a pretty dangerous place right now. Australia is well-placed and well-prepared to deal with all of this uncertainty and volatility, but we won't be immune from it.
According to the Australian Financial Review, the RBA would look through any temporary spike in inflation caused by higher oil prices. However, there is a chance that higher commodity prices could become the dominant driver of inflation over the next few months, making it harder to justify cutting rates.
Inflation data surprised investors in May, rising just 0.1%. Markets had expected a higher number, given the inflationary impact of tariffs, which had gone into effect. Experts have attributed this delay to flexible payment windows, mitigation strategies, and the technicalities of pricing inventories. However, tariff impacts could show up in later readings, and a prolonged spike in oil prices would also further complicate the RBA's decision-making.
Investors are currently pricing an 80% chance the RBA will cut the cash rate from 3.85% to 3.6% when it next meets on July 7-8. Stay tuned.
