When Kevin Warsh explained why the US Federal Reserve Board had lifted its policy rate for the first time in three years last week, he studiously avoided any direct references to the war in the Middle East.
Three things had changed, he said, since the Fedโs July meeting, when the Fed left the federal funds rate (the equivalent of the Reserve Bankโs cash rate) unchanged: the US economy had strengthened, inflation hadnโt slowed and the โgeopolitical landscapeโ was one of โshocks and uncertaintyโ.
With the US 10-year bond yield, the worldโs risk-free benchmark for assets, trading around 5 per cent, Warsh said economic strength, a surge in artificial intelligence-related expenditures and โhotspotsโ around the world โ particularly the differences between the spot prices of energy and the โso-called crack spreadsโ โ were driving long-term yields.
While Warsh might add growth and AI investment to the influences on US inflation, that begs the question of why other developed economies with less growth and lower AI investment โ from Australia and Japan to the European Union โ are also wrestling with persistently high inflation and their central banks are also raising their policy rates.
The answer lies within the Middle East. The war in the Middle East has driven up oil prices from around $US70 a barrel to over $US100 a barrel (it traded at almost $US110 a barrel on Friday) and, more particularly, has had a more dramatic impact on gasoline and diesel prices.
In the US, the average price of gasoline ahead of the attacks on Iran by the US and Israel in February was $US3.18 a gallon, with the average price of diesel $US3.70 a gallon. Today, the average gasoline price is $US4.47 a gallon and that of diesel $US6.50 a gallon โ a record.
The same holds true around the world, with the price of diesel at record levels in Europe and Asia and likely to surge further during the northern hemisphere winter.
Crude oil supply out of the Middle East is still well below pre-war levels despite some oil now being shipped out of the Strait of Hormuz, a big lift in production outside the region, and the worldโs strategic oil reserves still being deployed.
The picture for refined products like petrol and diesel is worse.
Not only have crude supplies been diminished, but the refining infrastructure in the Middle East has been targeted and significantly damaged by Iran. Ukraineโs campaign of drone attacks on Russiaโs refineries, which have turned the worldโs third-largest exporter of diesel into an importer, has compounded the damage.
While Donald Trump has blamed Ukraine for the soaring prices of gasoline and diesel (and told Ukraine to stop targeting Russiaโs refineries), Russia produces less than half the volumes of diesel of the Middle Eastern exporters.
The world is producing about 4.2 million barrels of diesel a day less than it did a year ago, with the refineries in the Middle East operating at about a quarter of their pre-war levels and Russiaโs production cut by about a third, according to the International Energy Agency.
With the war on Iran now into its seventh month, with no end in sight and Iran and the Houthis now increasingly targeting strategic oil infrastructure in the region โ including the Saudi Arabian refineries and its pipeline to the Red Sea that had allowed up to 5 million barrels a day to bypass the Strait of Hormuz โ thereโs little likelihood of the prices of either crude oil or, more critically, the prices of the refined products that businesses and households actually consume, subsiding.
In fact, with the largest-ever release of the 400 million barrels of oil from strategic reserves now slowing โ the IEA says 320 million barrels have been released โ a new and even more threatening phase for oil and refined product prices might be ahead, given that the Trump administration appears clueless when it comes to devising a way to extricate itself from its stalemated adventurism in the Middle East.
That implies more rate rises in the US and elsewhere.
With 24 hours of the Fedโs 25 basis point rate rise, the Bank of Japan followed up with a 25 basis point hike of its own. The European Central Bank raised its policy rate by the same amount earlier this month and Bank of England has foreshadowed rate increases if energy prices remain elevated.
Both inflation rates and interest rates have been significantly higher in the past than they are today, but their threat today relates to the record levels of global debt, particularly government debt. Global public debt is just under 100 per cent of global GDP, with the largest economies โ notably the US and China โ driving most of the growth.
In the US, thereโs a 50 per cent chance of another rate rise next month and a 90 per cent chance of it occurring by the end of the year, with at least two more pencilled in by the markets for 2027.
It is the interaction between that debt and interest costs that are surging in response to the inflationary impacts of the war in the Middle East, as well as the extraordinary call on capital markets for the financing of artificial intelligence and the physical infrastructure that supports that sector, which is a threat to stability.
The International Monetary Fundโs managing director, Kristalina Georgieva, said at the weekend that governments must do more to reduce their budget deficits and rein in global debt, which she said was projected to reach 100 per cent of global GDP by 2029, or two years earlier than the fund had previously expected.
โWe have been advocating with the US to pay attention to the fiscal position,โ she said.
โOut of our conversations with [Treasury] Secretary [Scott] Bessent, there is an understanding that this is not sustainable, that the US has to gradually bring deficit and debt down.โ
To date, while presiding over deficits that have grown to 2 per cent of US GDP and a $US4 trillion increase in government debt since January last year โ before Trump even reaches the halfway mark of his second term as president โ Bessentโs only strategy for dealing with the exploding debt and deficits has been, unsuccessfully, to try to manipulate the bond market with his bond buybacks.
He โ and other officials in similar positions โ has also been replacing maturing longer-term bonds with those of much shorter duration, which carry significantly lower yields, to reduce their interest costs.
Refinancing debt that costs 5 per cent with bills or notes that have yields that might be 25 to 100 basis points less might lower a governmentโs interest costs, but increase its vulnerability to external shocks.
If Warsh and his peers continue to do the heavy lifting of using the only tool at their disposal โ higher interest rates โ to lower inflation, of course, whatever savings that might be available from exploiting the shape of yield curves would be overwhelmed by the overall rise in interest rates.
In the US, thereโs a 50 per cent chance of another rate rise next month and a 90 per cent chance of it occurring by the end of the year, with at least two more pencilled in by the markets for 2027.
If diesel and other refined products continue to climb and continue to feed into transport costs and end-prices for businesses and consumers, most of the developed world will be challenged by increased inflation and rising interest costs that eat away at their capacity to fund measures that are more productive and popular than servicing their debts.
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