Restrictive for Longer: Energy Volatility Reshapes the Policy Outlook

The second quarter of 2026 was dominated by a sharp reassessment of inflation risk. At the start of April, investors were still broadly focused on the timing and scale of eventual monetary easing. By quarter-end, the debate had shifted toward the persistence of policy restraint, as the Iran conflict and wider Middle East instability injected a fresh supply shock into global energy markets. Disruption around the Strait of Hormuz amplified concerns about oil and gas availability, pushed energy prices higher through April and May, and revived memories of previous episodes in which headline inflation shocks spilled into wages, inflation expectations and central bank reaction functions. Although a preliminary U.S.–Iran agreement in mid-June to end hostilities and reopen the Strait helped ease the immediate risk premium in oil, the quarter left cash investors facing a more complex mix of elevated carry, increased policy uncertainty and renewed geopolitical tail risk

In the United States, the Federal Reserve (Fed) maintained the federal funds target range at 3.50%–3.75% through the quarter, but the tone of policy communications became more hawkish. The June FOMC statement emphasised that economic activity remained solid, unemployment was little changed and inflation remained elevated, with the Committee specifically acknowledging supply shocks including energy. The June Summary of Economic Projections reinforced that message: the median 2026 PCE inflation forecast was lifted to 3.6%, core PCE to 3.8%, signalling that policymakers saw less scope for near-term easing than markets had previously assumed. The political backdrop added another dimension to U.S. rate expectations. Kevin Warsh was sworn in as the Fed Chair in May following nomination by President Trump and Senate confirmation, a transition closely watched by markets for any sign of a change in the Fed’s reaction function. In practice, the June meeting suggested continuity rather than a dovish pivot. The unanimous decision to hold rates, combined with higher inflation projections, encouraged investors to price a longer period of restrictive policy.

In the Eurozone, the European Central Bank (ECB) faced a difficult trade-off between weaker growth and renewed inflation pressure. After holding rates earlier in the quarter, the ECB raised all three key policy rates by 25 basis points in June, taking the deposit facility rate to 2.25%, the main refinancing rate to 2.40% and the marginal lending facility rate to 2.65%. The Governing Council explicitly linked its decision to inflation pressures generated by the Middle East war, while staff projections showed headline inflation at 3.0% in 2026 and growth at only 0.8%. The message to markets was clear: growth risks had increased, but the ECB was unwilling to accommodate an energy-driven inflation shock before it had confidence that second-round effects would be contained.

In the United Kingdom, the Bank of England was similarly constrained by the energy shock, but the domestic backdrop was more fragile. The MPC held Bank Rate at 3.75% in April by an 8–1 vote and again in June by a 7–2 vote, with the dissenters in June preferring a 25-basis point increase. The Bank acknowledged that CPI YoY had fallen to 2.8% by the June meeting, but it expected inflation to rise later in 2026 as higher energy costs passed through. At the same time, UK activity indicators were softening, with the composite PMI slipping below 50 in May, underlying GDP growth subdued and unemployment rising to 4.9% in the three months to April.

As the quarter ended, the central question for Q3 was whether the Middle East de-escalation would prove durable enough to allow inflation expectations to stabilise. A sustained reopening of energy supply routes would support the case for policy rates to remain on hold and, eventually, for easing debates to resume. Conversely, any renewed disruption in Iran or the broader Gulf region could quickly revive inflation risk and force central banks to defend credibility even as growth slows.

The Eurozone was more directly exposed to the energy dimension of the Middle East shock. The region’s reliance on imported energy meant that higher oil and gas prices fed quickly into inflation expectations, business confidence and household sentiment. Eurostat’s May estimate showed euro area annual inflation rising to 3.2%, up from 3.0% in April, with energy recording the highest annual increase among major components. Services inflation also strengthened, which was important for the ECB because it raised the risk that the initial external shock could interact with domestic price-setting behaviour.

The ECB responded in June by tightening policy, explicitly citing the war in the Middle East as a source of inflation pressure. Its staff projections reflected the difficult trade-off facing the Governing Council: headline inflation was expected to remain above target in 2026, while growth expectations were weak. The ECB’s message was that the region was facing a supply shock, but that policymakers could not allow the shock to become embedded in medium-term inflation expectations. President Lagarde and other policymakers framed the move as a necessary response to realised inflation risks rather than a symbolic or insurance action.

The region was more directly exposed to imported energy costs, and the conflict in the Middle East reinforced concerns about competitiveness, household purchasing power and business confidence. Euro area GDP contracted by 0.2% in the first quarter of 2026 compared with the previous quarter, while annual growth slowed to just 0.3%. The weakness was broad enough to reinforce concerns that the economy was vulnerable to another external shock, particularly as investment and net trade both weighed on activity.

At the same time, inflation remained above the ECB’s target for much of the quarter. Euro area annual inflation rose to 3.2% in May before easing to 2.8% in June, according to Eurostat’s flash estimate. The June decline was notable because it suggested that the energy shock was beginning to fade as geopolitical tensions eased, but the composition of inflation still required caution. Energy inflation remained elevated at 8.7% in June, while services inflation stood at 3.2%. The ECB therefore faced a difficult trade-off: growth data argued for patience, but inflation data prevented policymakers from sounding relaxed.

Eurozone political developments were therefore closely linked to market sentiment. The debate was not only about monetary policy, but about whether Europe could respond to a second major energy shock in less than five years without undermining fiscal discipline or long-term competitiveness. Countries with stronger fiscal positions were better placed to absorb the shock, while more indebted members faced greater scrutiny. At the same time, the push for strategic autonomy, energy diversification and defence investment was viewed as structurally important but potentially costly. The ECB’s challenge was to maintain credibility while avoiding an excessive tightening of financial conditions in an economy already facing weak demand.

The United Kingdom faced a particularly difficult policy mix during the quarter. The Bank of England (BoE) left policy unchanged at both its April and June meetings, but the voting pattern became more hawkish by June, with a larger minority favouring additional tightening. The MPC was explicit that monetary policy could not influence global energy prices, but that it did need to ensure the adjustment to higher energy costs was consistent with a sustainable return to the inflation target. In June, the Bank noted that energy prices had fallen from their most stressed levels but remained higher than before the conflict and continued to be volatile.

The MPC held Bank Rate at 3.75% in April by an 8–1 vote and again in June by a 7–2 vote, with the dissenters in June preferring a 25-basis point increase.

The domestic data made the Bank’s decision especially challenging. Inflation had eased to 2.8% by the June meeting, but the Bank expected it to rise again later in the year as energy effects passed through. At the same time, growth momentum weakened. The flash UK composite PMI fell below the expansion threshold in May, signalling the first decline in private-sector output for more than a year, while labour-market data showed unemployment at 4.9% for the February-to-April period. These figures pointed to a softer economy, but not one weak enough to remove concerns about wage growth, pricing behaviour and inflation persistence.

Political uncertainty added a further layer of complexity. Prime Minister Keir Starmer announced his resignation in June after growing pressure within the Labour Party, with markets then turning their attention to the leadership transition and the policy stance of a successor government. The immediate reaction was described as relatively contained, but the episode still mattered because it raised questions over fiscal priorities, public spending, defence commitments and the government’s ability to maintain a credible economic framework at a time of external pressure.

For UK markets, the key issue was the absence of a clean policy narrative. A weakening economy would normally encourage expectations of a more supportive central bank stance, but energy-driven inflation and political uncertainty complicated that interpretation. Investors therefore treated UK assets with caution. The BoE’s communication suggested patience rather than complacency: policymakers were prepared to wait for more evidence, but the threshold for ignoring renewed inflation pressure had clearly risen. The result was a quarter in which growth concerns increased but did not dominate the policy debate.

In the United States, the quarter was defined by the tension between resilient domestic demand and a clear deterioration in the inflation backdrop. The May CPI data showed headline inflation increased, with energy accounting for more than sixty percent of the monthly increase. This was an important development because it suggested that the Middle East shock was no longer merely a commodity-market event; it was beginning to appear in household prices. At the same time, the labour market remained firm enough to prevent the Fed from placing greater weight on downside growth risks. May payrolls increased by 172,000 and unemployment was unchanged at 4.3%, reinforcing the view that the economy could absorb a restrictive policy stance for longer.

The Fed’s June meeting therefore became a pivotal event. The Committee left policy unchanged, but its statement emphasised that economic activity was expanding at a solid pace despite elevated uncertainty linked in part to the Middle East conflict. The accompanying projections showed inflation expectations within the Committee moving higher, while the implied policy path became less supportive of near-term easing. Markets interpreted this as a hawkish hold: the Fed was not rushing to tighten further, but it was clearly unwilling to validate expectations of imminent policy relief while inflation was being pushed higher by energy.

Political developments also mattered in the U.S.. Kevin Warsh was sworn in as the Fed Chair in May, following nomination by President Trump and confirmation by the Senate. His arrival was closely scrutinised because markets were alert to any sign that the central bank’s reaction function might shift under new leadership. In practice, the June meeting pointed more to continuity than rupture. The Fed’s message remained centred on price stability, inflation expectations and data dependence, rather than on political pressure for easier policy. That helped preserve institutional credibility at a moment when inflation had reaccelerated and the Middle East conflict had made the outlook unusually sensitive to non-domestic events.

In the U.S., the economy continued to show a degree of resilience, but the data increasingly suggested that growth was becoming less balanced. Real GDP expanded at an annualised pace of 2.1% in the first quarter of 2026, according to the Bureau of Economic Analysis, but the details were less reassuring than the headline.

The expansion was supported by investment, exports and government spending, while consumer demand showed signs of moderation. That mattered for markets because it suggested the economy was not weakening quickly enough to force a clear shift in the Fed policy, but it was also not strong enough to absorb a fresh inflation shock without creating additional inflationary pressure.

Inflation was the more important driver of sentiment during the quarter. U.S. CPI rose by 4.2% year-on-year in May, up from 3.8% in April, with energy prices increasing by 23.5% over the year and accounting for more than sixty percent of the monthly rise in headline CPI. Core CPI was more contained at 2.9%, but markets focused on the possibility that the energy shock could feed into broader price expectations if it persisted. This was why the Fed’s communication was interpreted as cautious rather than dovish. Even though policymakers did not signal an immediate need to tighten further, they also gave little encouragement to investors looking for a near-term easing cycle.

For U.S. markets, the result was a more cautious tone across risk assets and government securities. Investors were not pricing a classic slowdown alone; they were grappling with a less favourable mix of solid activity, higher energy costs and a central bank that had little room to look through another inflation shock. Fiscal considerations also remained in the background, with the Congressional Budget Office projecting a large federal deficit for 2026 and public debt continuing to rise over the coming decade. This reinforced concerns that even if growth slowed, policy support could be constrained by inflation and fiscal credibility.