The recent escalation of conflict involving Iran has heightened concerns over potential inflationary pressures and the likelihood of interest rate increases by the US Federal Reserve at its upcoming policy meeting. This session marks the second under the leadership of Fed Chair Kevin Warsh.

Just a week prior, futures markets had priced in less than a 10 percent probability of a quarter-point rate hike. However, a surge in oil prices above $100 per barrel—the highest since May—pushed the odds to approximately 36 percent by Friday. Markets now fully anticipate a rate increase by September, with the possibility of one or two additional hikes over the subsequent nine months.

Since the outbreak of hostilities in late February, oil prices have fluctuated significantly in response to intermittent fighting and tense diplomatic standoffs between Washington and Tehran. Investors initially projected any inflationary impact from restrictions in the Strait of Hormuz, a critical passage for one-fifth of global oil supplies, would be temporary. The recent spike in crude prices has challenged that view, prompting a broad sell-off in sovereign bonds worldwide. This sell-off led to a decline in bond prices and a rise in yields, with the 10-year US Treasury yield climbing to its highest level in 18 months. Similarly, 10-year government bond yields in Germany and France reached peaks not seen in over 15 years. Rising long-dated bond yields are generally indicative of increased inflation expectations.

Supporting the case for tightening monetary policy, the US economy remains robust with a strong labor market. Weekly jobless claims recently fell to their lowest since 1969, while consumer inflation in June accelerated to an annual rate of 3.5 percent, well above the Fed’s 2 percent target. Despite these developments, uncertainty persists partly due to Warsh’s decision not to provide explicit forward guidance on the Fed’s future policy path. “July is live, baby,” said Adel Al-Hussainy, portfolio manager at Columbia Threadneedle, underscoring the view that recent inflation and labor market data strengthen the argument for a rate increase.

Across the Atlantic, the Bank of England (BoE) is facing a different set of dynamics as it prepares for its own policy meeting Thursday. While oil’s rebound to near $100 per barrel has raised concerns about inflation, markets currently assign just an 11 percent chance of a rate hike, with the benchmark interest rate expected to remain at 3.75 percent. UK inflation eased more than anticipated in June, falling to a 15-month low of 2.6 percent, and recent GDP figures indicate sluggish economic growth, which together have raised the threshold for tighter policy.

Nonetheless, the resurgence in energy prices remains a material risk for future inflationary pressures. Sonali Punhani, chief UK economist at Bank of America, noted that although the energy price surge may eventually feed through to core inflation and wages, there is currently limited evidence of such transmission. Additionally, minutes from the BoE’s last meeting reflected a cautious stance, with policymakers indicating no urgency to adjust rates immediately.

While the BoE is expected to hold steady this week, investors will closely monitor Governor Andrew Bailey’s remarks for any signals of a more hawkish approach amid the evolving inflation outlook linked to elevated oil costs.