The war in the Middle East is driving oil and refined fuel prices sharply higher, putting renewed pressure on inflation and increasing the prospect of further interest rate rises across the developed world.
Kevin Warsh, chair of the US Federal Reserve, avoided directly mentioning the conflict when explaining last week’s decision to raise the federal funds rate for the first time in three years. Instead, he pointed to a stronger US economy, persistent inflation and a “geopolitical landscape” marked by “shocks and uncertainty”.
Oil prices have risen from about US$70 a barrel to more than US$100 since the conflict began, reaching almost US$110 on Friday. The impact has been even more severe on petrol and diesel, which feed directly into transport costs and the prices paid by businesses and households.
In the US, average petrol prices have climbed from US$3.18 a gallon before the attacks on Iran by the US and Israel in February to US$4.47. Diesel has risen from US$3.70 to US$6.50 a gallon, a record level.
Diesel prices are also at record levels in Europe and Asia, with further increases expected during the northern hemisphere winter. The supply of crude oil from the Middle East remains well below pre-war levels, despite some shipments moving through the Strait of Hormuz, increased production elsewhere and the continued release of strategic reserves.
Middle East war threatens refined fuel supplies
The outlook for refined products is more troubling than for crude oil. Refineries in the Middle East have been significantly damaged by Iran, while Ukraine’s drone attacks on Russian refineries have compounded the disruption.
Russia, previously the world’s third-largest diesel exporter, has become an importer after its production fell. Donald Trump has blamed Ukraine for rising petrol and diesel prices and urged it to stop targeting Russian refineries, although Russia produces less than half the diesel volumes generated by Middle Eastern exporters.
The International Energy Agency estimates that global diesel production is about 4.2 million barrels a day below its level a year ago. Middle Eastern refineries are operating at about a quarter of their pre-war capacity, while Russian production has fallen by roughly a third.
The conflict has now entered its seventh month, with no end in sight. Iran and the Houthis are increasingly targeting strategic oil infrastructure, including Saudi Arabian refineries and a pipeline to the Red Sea that had enabled up to five million barrels a day to bypass the Strait of Hormuz.
That has raised the prospect that crude and refined fuel prices will remain elevated, particularly as the release of oil from strategic reserves slows. The IEA says 320 million barrels have been released from the largest-ever deployment of the reserves, totalling 400 million barrels.
Higher rates add to global debt pressure
Central banks are already responding to the inflationary effects of higher energy costs. The Federal Reserve raised its policy rate by 25 basis points last week, followed within 24 hours by a similar increase from the Bank of Japan. The European Central Bank increased its rate by the same amount earlier this month, while the Bank of England has indicated that it could raise rates if energy prices remain high.
Markets are pricing in a 50 per cent chance of another US rate rise next month and a 90 per cent chance of an increase by the end of the year. At least two further increases have been pencilled in for 2027.
The pressure is particularly significant because global public debt is now just below 100 per cent of global economic output. The US and China are responsible for much of the increase, while the International Monetary Fund expects debt to reach 100 per cent of global GDP by 2029, two years earlier than previously forecast.
Kristalina Georgieva, the IMF’s managing director, said governments needed to reduce budget deficits and rein in borrowing. She said the US had to “gradually bring deficit and debt down”, after discussions with Treasury secretary Scott Bessent.
US government debt has increased by US$4 trillion since January last year, while the deficit has grown to 2 per cent of GDP. The administration has sought to lower interest costs partly by replacing maturing long-term bonds with shorter-duration debt carrying lower yields.
However, refinancing debt at about 5 per cent with borrowing that is 25 to 100 basis points cheaper also leaves governments more exposed to external shocks. If central banks continue raising rates to contain inflation, any savings from changing the maturity of government debt could be outweighed by the broader increase in borrowing costs.
Further increases in diesel and other refined fuel prices would feed into transport and consumer costs, leaving much of the developed world facing a combination of higher inflation and rising interest bills that restricts the money available for other government priorities.
